Question

Under what circumstances would it be appropriate for a firm to use different costs of capital for its different operating divisions? If the overall firm WACC were used as a hurdle rate for all divisions, would the riskier divisions or the more conservative divisions tend to get most of the investment projects? Why? Make sure to explain your answers.

Answer 1

Solution:-

In order to understand the required scenario, let's first take a look at what cost of capital signifies and what is its importance in evaluating investment decisions.

Every company needs capital to invest money in the business and that capital is given by investors with an objective of generating returns on their investments. How much return the investors expect, i.e. what the cost of capital should be is completely dependent on the underlying risk of the business where the capital is to be invested. Higher the risk, higher would be the expected return and vice-versa.

In cases where a company has multiple businesses and operates in multiple industries, its various business divisions may have different risks and thus the capital invested in them may deserve different financial returns. In other words, the cost of capital for different divisions vary from each other and thus when the company is evaluating the viability of a project in one of its divisions , it must use cost of capital for that particular operating division and not the WACC for the whole company. This would ensure that the firm correctly analyzes the required rate of return from that project and thus the financial analysis yields the expected results.

Impact of WACC being used as a hurdle rate for all divisions:

If the company-wide WACC is used as a hurdle rate to analyze the investments of all divisions, it would mean that the riskier divisions would get more investment than they deserve and the conservative divisions wouldn't attract the level of investment that they deserve. This is explained as follows with the help of an example:

For e.g.: Let's say that a company has 2 divisions with division A's business riskier than division B's business. The company-wide WACC is 15% and therefore, it means that the required rate of return of division A would be higher than 15% and that of division B would be lower than 15%. If the management uses 15% as hurdle rate to analyse projects of both divisions, it would mean that if any of project A's investments have an expected rate of return of 15%, they would be accepted even though the required rate of return for division A is higher than 15%. Similarly, if project B's investments have an expected rate of return anything less than 15%, they would be rejected even though the required rate of return for project B is lower than 15%.

To summarise, the riskier projects have a cost of capital higher than the company WACC while the conservative projects have cost of capital lower than the company WACC, and thus if overall WACC is used, it results in riskier divisions attracting more investments than they should while the conservative divisions miss out on investments that meet the criteria.