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. Interest rates in the economy The firm's dividend payout ratio The performance of index funds, such as the S&P; 500 The impact of a firm's cost of capital on managerial decisions Consider the following case: Lancashire Railway Company (LRC) 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 L is considering a project with an expected return of 9.5%. Should Lancashire Railway Company (LRC) accept or reject the project? Accept the project O Reject the project On what grounds do you base your accept-reject decision? Division L's project should be accepted, since its return is greater than the risk-based cost of capital for the division. Division L's project should be accepted, because its return is less than the risk-based cost of capital for the division.

Explanation / Answer

Interest rates in the economy and the performance of index funds, such as S&P 500 are outside firm's control. The firm can control its dividend payout ratio.

LRC should accept the project as expected return from division L is 9.5% which is greater than the wacc of division L of 8%.

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