Question

Each of the following factors affects the weighted average cost of capital (WACC) equation. Which of the following factors are outside a firm’s control? Check all that apply.

The general level of stock prices

The effect of the tax rate on the cost of debt in the weighted average cost of capital equation

The firm’s capital budgeting decision rules

Edinburgh Exports 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 Edinburgh Exports accept or reject the project?

Accept the project

Reject the project

On what grounds do you base your accept–reject decision?

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

Part a)

The following factors affecting the WACC cannot be controlled by the firm:

1) The general level of stock prices (which is Option A)

2) The effect of the tax rate on the cost of debt in the weighted average cost of capital equation (which is Option B)

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Explanation:

WACC is affected by both internal and external factors. While internal factors such as investment policy (such as decision with respect to acceptance or rejection of projects), dividend payment policy (such as how much of the profits should be distributed as dividends or retained within the company for expansion) and capital budgeting policy (such as the proportion of debt or equity to be included in the capital structure) are within the control of the firm, external factors such as tax rate (which is set by the government) and stock prices (which are affected by socio-economic factors, political situation within the country and so on) are not within the control of the firm.

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Part b)

Should Edinburgh Exports accept or reject the project?

Reject the project. (which is Option B)

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On what grounds do you base your accept–reject decision?

Division H’s project should be rejected since its return is less than the risk-based cost of capital for the division. (which is Option B)

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Explanation for both of the Above Questions

Generally, projects providing a rate of return greater than the cost of capital are accepted by the organization. In the given case, Division H's project has an expected rate of return of 12% which is less than its WACC of 12%.