A company has two divisions, A and B. Division A is the company\'s low risk divi

Question

A company has two divisions, A and B. Division A is the company's low risk division and would have a WACC of 8% if it were operated as an independent company. Division B is the company's high risk division and would have a WACC of 14% if it were operated as an independent company. Because the two divisions are the same size, the company has composite of WACC of 11%. Division B is considering a new project with an expected return of 12%.

1. Should company accept or reject the project?

Accept or Reject

2. On what grounds do you base you accept or reject decision?

A. Division B's project should be rejected, because its return is less thant the risk based cost of capital for the division.

B. Division B's project should be accepted, because its return is greater than the risk based-based cost of capital for the division.

Explanation / Answer

Discussion: A project can only be accepted if it is expected to generate a return more than the required rate of return i.e. the WACC. Now as provided in the question, division B has a project under consideration with an expected return of 12% against the WACC of 14% of division B. It should be rejected because WACC exceeds project expected return. It is clear that this project will be value erosion for division B.

Answer 1

Project should be rejected.

Answer 2

A. Division B's project should be rejected, because its return is less thant the risk based cost of capital for the division.

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