s. The Tierney Group has two divisions of equal size: an office furniture manufa
ID: 2805305 • Letter: S
Question
s. The Tierney Group has two divisions of equal size: an office furniture manufacturing division and a data processing division. The CFO estimates that stand-alone data processor companies have a wACC of 9%, while stand-alone furniture manufacturers have a WACC of 13% and that Tierney's data processing and furniture divisions have the same risk as their typical peers. Consequently, he estimates that the corporate WACC is 11%. A consultant has suggested using a 9% cost of capital for the data processing division and a 13% cost of capital for the manufacturing division. However, the CFO disagrees and has assigned an 11% wACC to all projects in both divisions. Which of the following statements is correct? a. The decision not to adjust for risk means that the company is in effect favoring the data processing division. Therefore, that division is likely to become a larger part of the consolidated company over time. b. The decision not to adjust for risk means that the company will accept too many projects in the manufacturing business and too few projects in the data processing business. This will lead to a reduction in the firm's intrinsic value over time. While the decision to use just one corporate-level WACC will result in Tierney accepting more projects in the manufacturing division and fewer projects in the data processing division than if it followed the c. consultant's recommendation, this should not affect the firm's intrinsic value. The decision not to adjust for risk means that the company will accept too many projects in the data processing business and too few projects in the manufacturing business. This may affect the firm's capital d. structure but it will not affect its intrinsic value.Explanation / Answer
Correct option is B. Since the cost of capital i.e. WACC is low for data processing business and high for manufacturing business and assigning same cost to both the division will increase the chances of low earning manufacturing projects to get selected since the cost reduces after averaging the WACC. Now, because of this the intrinsic value will decrease. And also it will lead to the increase in selection of more manufacturing projects since the WACC becomes favorable for them.
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