Assignment 10-The Cost of Capital Aa Aa 9. Adjusting the cost of capital for ris

Question

Assignment 10-The Cost of Capital Aa Aa 9. Adjusting the cost of capital for risk Divisional Costs of Capital A firm's cost of capital is often a reflection of its activities and funding needs. Consider the case of Wizard Company, and answer the following questions: Wizard Co. currently has only a real estate division and uses only equity capital; however, it is considering creating consulting and distribution divisions. Its beta is currently 1.4. The risk-free rate is 4.4%, and the market-risk premium is 6.1%. o 8.80% ? 10.56% ? 12.94% 4.40% This means that the firm's real estate division will have a cost of capital of: The consulting division is expected to have a beta of 1.8, because it will be riskier than the firm's real estate division. ? 16.33% O 16.73% ? 17.88% O 15.38% This means that the firm's consulting division will have a cost of capital of: The distribution division will have less risk than the firm's real estate division, so its beta is expected to be 0.7 ? 16.13% ? 8.67% 17.33% 17.43% This means that the distribution division's cost of capital will be: ? Wizard Co. expects 60% of its total value to end up in the real estate division, 25% in the consulting division, and 15% in the distribution division. 14.24% O 17.69% 15.79% ? 12.94% Based on this information, what rate of return should its investors require once it opens the new divisions? O Ask me anything

Explanation / Answer

Cost of capital = risk free rate + beta * ( market risk premium )

ans 1) cost of capital = 4.4% + 1.4*6.1% = 12.94%

ans 2) cost of capital = 4.4% + 1.8*6.1% = 15.38%

ans 3) cost of capital = 4.4% + .7*6.1% = 8.67%

ans 4) cost of capital = .6*12.94% + .25*15.38% + .15*8.67% = 12.94%

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