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fm10 18 - capital budgeting decision has been made l Harry...

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Mini Case: 10 - 18 k. What procedures are used to determine the risk-adjusted cost of capital for a particular division? What approaches are used to measure a division’s beta? Answer: The following procedures can be used to determine a division’s risk-adjusted cost of capital: (1) Subjective adjustments to the firm’s composite WACC. (2) Attempt to estimate what the cost of capital would be if the division were a stand-alone firm. This requires estimating the division’s beta. The following approaches can be used to measure a division’s beta: (1) Pure play approach. Find several publicly traded companies exclusively in the project’s business. Then, use the average of their betas as a proxy for the project’s beta. (It’s hard to find such companies.) (2) Accounting beta approach. Run a regression between the project’s ROA and the S&P index ROA. Accounting betas are correlated (0.5 - 0.6) with market betas. However, you normally can’t get data on new project ROAs before the
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Unformatted text preview: capital budgeting decision has been made. l. Harry Davis is interested in establishing a new division, which will focus primarily on developing new internet-based projects. In trying to determine the cost of capital for this new division, you discover that stand-alone firms involved in similar projects have on average the following characteristics: • Their capital structure is 10 percent debt and 90 percent common equity. • Their cost of debt is typically 12 percent. • The beta is 1.7. given this information, what would your estimate be for the division’s cost of capital? Answer: r s DIV. = r RF + (r M- r RF )b DIV. = 7% + (6%)1.7 = 17.2%. WACC DIV. = w d r d (1 - T) + w c r s = 0.1(12%)(0.6) + 0.9(17.2%) = 16.2%. The division’s WACC = 16.2% vs. The corporate WACC = 11.1%. The division’s market risk is greater than the firm’s average projects. Typical projects within this division would be accepted if their returns are above 16.2 percent....
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