Richard works for a firm that is expanding into a completely new line

Richard works for a firm that is expanding into a completely new line of business. He has been asked to determine an appropriate WACC for an average-risk project in the expansion division.

Richard finds two publicly traded stand-alone firms that produce the same products as his new division. The average of the two firms’ betas is 1.25. Further, he determines that the expected return on the market portfolio is 13.00% and the risk-free rate of return is 4.00%. Richard’s firm finances 50% of its projects with equity and 50% with debt, and has a before-tax cost of debt of 9% and a corporate tax rate of 30%. What is the WACC for the new line of business?
A) About 12.64%
B) About 13.00%
C) About 10.78%
D) About 11.29%

ANSWER

Answer: C
Explanation: C) Re = rf + [E(rm) – rf] β = 4% + (13% – 4%) × 1.25 = 15.25%
WACC = × Rd × (1 – Tc) + × Re = 0.50 × (9.00%) × (1 – .30) + 0.50 × (15.25%) = 10.775%, or about 10.78%.