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. Tax rate The inflation rate The firm's capital structure The impact of cost of capital on managerial decisions Consider the following case: Anderson Animations Corporation (AAC) 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 Anderson Animations Corporation (AAC) 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 rejected since its return is less than the risk-based cost of capital for the division. Division H's project should be accepted, as its return is greater than the risk-based cost of capital for the division.

Answer 1

1: Options 1 and 2

The tax rate and inflation rate are determined by government and economic forces and hence they are beyond the control of the company. The capital structure is determined by the management and hence it is a controllable factor.

2: reject the project

Since the cost of capital of H division is greater than the returns from the project, it will not be beneficial to invest in it and hence the project should be rejected.

3: Option 1

The return from the project is 12% whereas the risk adjusted cost is 14% and hence the return is lesser than the cost.