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Cost of Capital

1) Canyon Inc. has two divisions: Division A makes up 50 percent of the company, while Division B makes up the other 50 percent. Canyon's beta is 1.2. Looking at stand-alone competitors, Canyon's CFO estimates that Division A's beta is 1.5, while Division B's beta is 0.9. The risk-free rate is 5 percent and the market risk premium is 5 percent. The company is 100 percent equity-financed. (WACC = ks, the cost of equity).

Division B is considering the following projects given below. Each of the projects has the same risk and all have the same risk as a typical Division B project.

Project Capital required IRR

1 $400 million 14.0%
2 300 million 10.7
3 250 million 10.5
4 320 million 10.0
5 230 million 9.0

The company is debating which cost of capital they should use to evaluate Division B's projects. Tom Flood argues that Canyon inc should use the same cost of capital for each of its divisions, and believes it should base the cost of equity on Canyons overall beta. Marvin barnes argues that the cost of capital should vary for each division, and that Division B's beta should be used to estimate the cost of equity for Division B's projects.
If the company uses Marvin Barnes's approach, how much larger will the capital budget be than if it uses Tom Floods approach?

a. Capital budget is $320 million larger using Marvin Barnes's approach.
b. Capital budget is $550 million larger using Marvin Barnes's approach.
c. Capital budget is $870 million larger using Marvin Barnes's approach.
d. Capital budget is $1,200 million larger using Marvin Barnes's approach.
e. The capital budget is the same using the two approaches.

Solution Preview

We first find the cost of capital under the two approaches. We use the CAPM formula to calculate the cost of capital.
For Tom Flood the beta is 1.2 and for Marvin it is 0.9
Risk free rate = 5% and market risk premium is ...

Solution Summary

The solution explains a problem relating to cost of capital.

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