A corporation operates three divisions. Once division involves significant resea

Question

A corporation operates three divisions. Once division involves significant research and development, and thus has a high-risk cost of capital of 15%. The second division operates in business segments related to the Corporation's core business and this division has a cost of capital of 10% based upon its risk. The corporation's core business is the least risky segment with a cost of capital of 8%. The firm's overall weighted average cost of capital of 11% has been used to evaluate capital budgeting projects for all three divisions. This approach will do what (and why):
A - favor projects in the core business division because that division is the least risky.
B - favor projects in the research and development division because the higher risk projects look more favorable if a lower cost of capital is used to evaluate them.
C - not favor any division over the other because they all use the same company wide weighted average cost of capital.
D - favor projects in the related business division because the cost of capital for this division is the closest to the firm's weighted average cost of capital.

Thanks

Explanation / Answer

The answer is B. Here is why.

One of the most important relationships in corporate finance (the study of which projects companies should undertake) is that RISK and REWARD are positively correlated, that is to say, in order to take on more risk, more return should be rewarded. The issue with using a constant WACC across an entire company is that it will overvalue Riskier projects but undervalue less risky projects.

Lets take an example of an R&D cash flow, say for a new experimental drug, NEW. Your company may have spent millions of dollars developing drug NEW but there is no guarantee that the drug will work or that the FDA will accept it, it will be safe to use, etc. This means that the cash flows associated with selling the drug are UNCERTAIN and because of this, they are risky. To compensate for this risk, a higher discount rate must be used. But that implies that the discount rate used should be project specific, i.e. risk specific. Each project a company undertakes has a specific level of risk and the discount rate needs to account for that.

Hope this helps.

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