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Howard Power and Telecommunications corporation has 3 divisions. The names of these divisions,...

Question:

Howard Power and Telecommunications corporation has 3 divisions. The names of these divisions, along with the after-tax cost of capital for each division and the market value of the assets in each division, are as follows:

Division Name Cost of Capital MV of Assets

Infrastructure Development 8.75 $250,000,000

Power 7.50 $325,000,000

Telecommunications 8.25 $675,000,000

What is the overall after-tax cost of capital for Howard Power and Telecommunications?

Divisional Cost of Capital

When a firm has more than one division (line of business), the cost of capital of each division will be different based on the risk of the business. The business with lower risk will have a lower cost of capital, whereas the one with a higher risk will have a higher cost of capital.The overall cost of capital will be the weighted average of the cost of capital for each division.

Answer and Explanation:

  • Overall cost of capital can be calculated as follows:

Division MV of assets Weights Cost of capital Weights * cost
Infra 250,000,000 0.20 8.75 1.75
Power 325,000,000 0.26 7.50 1.95
Telecom 675,000,000 0.54 8.25 4.455
Total 1250,000,000 1 8.155

  • The weights assigned will be based on the market value of business.For example, the weight assigned for infrastructure division = 250,000,000 / 1250,000,000 = 0.20

The total of weights will be equal to 1

  • The sum of the last column (weights * cost) will be the overall cost of capital

The overall cost of capital for the company is 8.155 or 8.16%


Learn more about this topic:

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Divisional Cost of Capital

from Finance 101: Principles of Finance

Chapter 14 / Lesson 6
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