SAFCo is invested in two industries, the K Industry and the P Industry. It has two divisions, the K division and the P division, neither of which have traded shares.

K division has an attributed debt of $150M, financing assets of market value $500M.

P division has an attributed debt of $100M, financing assets of market value $1,000M.

To calculate appropriate divisional costs of capital it is established that comparable traded firms in the P industry support an average of 10% Debt to 90% Equity, and have asset betas of 1.2, whereas comparable firms in the K industry support an average of 35% Debt to 65% Equity, and have stock betas of 1.2.

The market risk premium is estimated as 6%p.a. The risk-free rate is estimated at 5%p.a. The tax rate is 40%. Firms in both divisions have an implied interest rate of 7%p.a. on borrowings.

a (8 marks) Estimate the Cost of Equity capital and the WACC for divisions K & P. Estimate K first, using it to explain clearly each step, including how and why you use the appropriate beta leveraging formula (which does not have a tax term).

b (3 marks) What is Business Risk? Which division of SAFCo has the greatest business risk? Why?

c (3 marks) For any business unit (e.g., firm or division), if the unit mistakenly uses an estimated WACC lower than its true underlying WACC, explain what the effects on investment and shareholder value will be for the unit.