Question

Each of the following factors affects the weighted average cost of capital (WACC) equation. Which are factors that a firm cannot control? Check all that apply. The firm's capital budgeting decision rules The firm's dividend payout ratio □ The general level of stock prices Interest rates in the economy The impact of cost of capital on managerial decisions Consider the following case: International Imports (12) has two divisions, L and H. Division L is the company's low-risk division and would have a weighted average cost of capital of 8% if it was operated as an independent company. Division H is the company's high-risk division and would have a weighted average cost of capital of 14% if it was operated as an independent company. Because the two divisions are the same size, the company has a composite weighted average cost of capital of 11%. Division H is considering a project with an expected return of 12%. Should International Imports (I2) accept or reject the project? O Reject the project O Accept the project On what grounds do you base your accept-reject decision? O Division H's project should be accepted, as its return is greater than the risk-based cost of capital for the division. Division H's project should be rejected since its return is less than the risk-based cost of capital for the division

Answer 1

Answer 1:

The following two statements are being checked:

The general level stock prices

Interest rates in the economy.

Explanation:

The firm cannot control general level of stock prices since they are dependent on multiple factors including demand and supply which are beyond its control.

The firm also cannot control interest rates in the economy since interest rate in the economy is influence by multiple factors including monetary and fiscal policies of the Government.

The firm can define/modify/control its capital budgeting decision rules and its dividend payout ratio.

Answer 2 1st part:

Correct answer is:

Reject the project.

Explanation:

In case of companies having multiple divisions with heterogeneous risk profiles, it is not prudent to use single company level WACC to evaluate specific projects of divisions. It should use division wise WACCs (calculated based on respective division wise betas). The WACC of respective division should be used to evaluate specific projects of the divisions.

Division H is a high risk division and it would have WACC = 14% if it would operate as independent company. If the project, division H is considering, has an expected rate of return = 12%, it should reject the project since the project's rate of return is less than WACC of division H.

Answer 2 2nd part:

Correct answer is:

Division H's project should be rejected since its return is less than the risk based cost of capital for the division.

Explanation:

Please see explanation as given in answer above (of 1st part)