Each of the following factors affects the weighted average cost of capital (WACC

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. The general level of stock prices The effect of the tax rate on the cost of debt in the weighted average cost of capital equation The firm's capital budgeting decision rules The impact of cost of capital on managerial decisions Consider the following case: Wellington Industries 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 Wellington Industries accept or reject the project? O Reject the project Accept 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

Explanation / Answer

1. a)The general level of stock prices
b)The effect of tax rate on the cost of debt in the WACC equation
Here a and b are correct option because stock prices are dependent on macroeconomic factor and company's performance. since the macroeconomic factor like interest rates, inflation ,etc. can't be controlled so stock price can't be controlled in long run. In short run the firms can control to some extend by share purchase or issuing more shares.
Tax rate is determined by the government and is not under control of company.
Firms' capital budget decision is completely controlled by the company

2. Wellington should reject the project

3. Division H's project should be rejected because its return is less than risk based cost of capital of the division.
Since Cost of Capital = 14% and Expected return = 12%.If the company goes ahead with the project the value of the company will decrease.

Best of Luck. God Bless

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