Pearson & Sons has two divisions: A, which produces peanut butter, and B, which

Question

Pearson & Sons has two divisions: A, which produces peanut butter, and B, which produces jam. Division A, the largest division and riskiest, represents 80 percent of the firm's revenue. When management is deciding which of the various divisional projects should be accepted, the managers should:

Allocate more funds to Division A since it is the largest of the two divisions.

Allocate the company's funds to the projects with the highest net present values based on the firm's weighted average cost of capital.

Fund all of Division B's projects first since they tend to be less risky and then allocate the remaining funds to the Division A projects that have the highest net present values.

Assign appropriate, but differing, discount rates to each project and then select the projects with the highest net present values.

Fund the highest net present value projects from each division based on an allocation of 70 percent of the funds to Division A and 30 percent of the funds to Division B.

Explanation / Answer

The problem statement does not mention anything about the firm's risk appetite and hence it cannot be assumed that the firm will simply bypass the riskiest project and allocate all funds to division B. Further, there is no guarantee that the larger division is going to return better profits. Therefore, both statements A and C are false. The firm should definitely take up the divisional projects with the highest NPVs as the same would accrue value to the firm. However, the NPV should not be determined using a firm-wide weighted average cost of capital as doing so tacitly implies that all divisions and projects across the firm have same risk-levels which is not the case. Hence, statement B is also false. Allocation of funds to division A and B in the ratio of 7:3 is both arbitrary and incorrect. Hence, statement E is also false.

The statement D says that one should choose projects with highest NPVs but these NPVs need to be calculated at different yet appropriate discount rates which is indeed true because the differing yet appropriate discount rates will reflect the requisite risk level of each project. Hence, the statement D is true.

Related Questions

Navigate

• Browse (All)
• Browse P
• Subjects

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.