Question

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

The firm’s capital structure

Tax rates

The firm’s dividend payout ratio

The firm’s capital budgeting decision rules

The impact of cost of capital on managerial decisions

Consider the following case:

International Imports (I2) 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?

Reject the project

Accept 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

The firm's capital structure affects the weighted average cost of capital since the different types of share capital is financed at different rates and thus, the firm's capital structure will affect the WACC.

Tax rates also affect the weighted average cost of capital since it is required to calculate the after tax cost of debt.

The dividend payout ratio also affects the WACC because it affects the growth rate which is used in the Dividend Discount Model to find the cost of equity and therefore, it affects the WACC.

The firm's capital budgeting decision rules does not affect the weighted average cost of capital because the WACC is used to discount the cash flows to find out the NPV

The impact of cost of capital on managerial decisions does not affect the WACC because it used to make decisions and is not factored in the WACC

CASE

International Imports(I2) should accept the project.

Division H’s project should be accepted, as its return is greater than the risk-based cost of capital for the division. For example, the cash inflow would be 100, expected return is 12% and the cost of capital is 11% , the present value of this inflow is 100*12/11 would be 109.10