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

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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 divisions 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 divisions WACC = 16.2% vs. The corporate WACC = 11.1%. The divisions market risk is greater than the firms average projects. Typical projects within this division would be accepted if their returns are above 16.2 percent....
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