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In: Accounting

Based on a company's structure, it should use multiple divisional weighted average costs of capital to...

Based on a company's structure, it should use multiple divisional weighted average costs of capital to accurately evaluate investment decisions. If this company instead uses a single company-wide WACC, what will be the effect on the division with low-risk projects?

more projects will be accepted due to the single WACC being higher than the divisional WACC

more projects will be rejected due to the single WACC being higher than the divisional WACC

more projects will be rejected due to the single WACC being lower than the divisional WACC

How do flotation costs affect the cost of debt and equity?

increases the cost of capital

has no effect on the cost of capital

all of the above

Which of the following is NOT an advantage to using a single company-wide weighted average cost of capital?

it requires less estimation made by the company

it potentially reduces influence cost issues between divisions

it allows the company to more accurately evaluate projects when divisions have varying level of risk and capital structure

Solutions

Expert Solution

1. Answer: more projects will be rejected due to the single WACC being higher than the divisional WACC

If a multidivisional firm uses a firm-wide WACC, this rate will be too high for low-risk divisions and too low for high-risk divisions. The firm will accept bad high-risk projects and reject good low-risk projects.

So the correct option will be more projects will be rejected due to the single WACC being higher than the divisional WACC

2. Increases the Cost of Capital

Flotation costs are costs a company incurs when it issues new stock. Flotation costs make new equity cost more than existing equity.Since flotation expenses affect the amount of capital that can be raised by issuing new securities, the costs impact a company’s cost of capital.

Cost of Equity = (Dividend /Current share price(1-floatation cost in percentage)}+growth rate of dividends

As introduction of floatation cost will reduce the value of denominator which will lead to increase in the value of cost of equity.Increase in cos of equity will increase the cost of capital.

3. it allows the company to more accurately evaluate projects when divisions have varying level of risk and capital structure

Single WACC reduces the estimation cost as estimation of cost of all divisions are not required to be calculated.

In single WACC calculation Division wise cost are least important it reduces the problem of influence cost issues between divisions as every divisions have to adopt same WACC irrespective of other factors.

When diviosns have varying level of risk and capital structure adoption of single WACC may result in wrong evaluation projects.The single WACC rate will be too high for low-risk divisions and too low for high-risk divisions. The firm will accept bad high-risk projects and reject good low-risk projects.So inaccurate evaluation of projects occurs.

ekkarill92 answered 1 year ago
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