Divisional Costs of Capital A firm\'s cost of capital is often a reflection of i
ID: 2787241 • Letter: D
Question
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; ho divisions. Its beta is currently 1.4. The risk-free rate is 4.2%, and the market-risk premium is 5.2%. lting 11.48% 4.20% 10.08% 8.40% wever, it is considering creating consu and distribution 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 16.06% 13.56% 14.51% 14.91% 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 6.28% 15.61% 14.31% 15.51% so its beta is expected to be 0.4 This means that the distribution division's cost of capital will be: wizard Co. expects 65% of its total value to end up in the real estate division 25% in the consulting division, and 10% in the distribution division. 16.23% 14.33% 11.48% 12.78% Based on this information, what rate of return should its investors require once it opens the new divisions?Explanation / Answer
According to CAPM,
Expected return = risk free rate + beta*market risk premium
Real estate:
Expected return = 4.2% + 1.4*5.2% = 11.48%
Consulting:
Expected return = 4.2% + 1.8*5.2% = 13.56%
Distribution:
Expected return = 4.2% + 0.4*5.2% = 6.28%
Total:
It is the weighted average of individual returns
Total expected return = 0.65*11.48% + 0.25*13.56% + 0.1*6.28% = 11.48%