Swizer Industries has two separate divisions. Division X has less risk so its projects are...

Question:

Swizer Industries has two separate divisions. Division X has less risk so its projects are assigned a discount rate equal to the firm's WACC minus 0.5 percent. Division Y has more risk and its projects are assigned a rate equal to the firm's WACC plus 1 percent. The company has a debt-equity ratio of 0.45 and a tax rate of 35 percent. The cost of equity is 14.7 percent and the after-tax cost of debt is 5.1 percent. Presently, each division is considering a new project. Division Y's project provides a 12.3 percent rate of return and division X's project provides an 11.64 percent return.

Which projects, if any, should the company accept?

Divisional Cost of Capital

The divisional cost of capital can be greater or lesser than the weighted average cost of capital of a company depending on the riskiness of the division's projects. The division should accept projects which meet the required rate of return on a given project.

Answer and Explanation:

Given the above information about Swizer Industries, we can calculate the weighted average cost of capital (WACC).

{eq}WACC = W_d*K_d*(1-T)+W_e*K_e {/eq}

{eq}WACC = (0.45/1.45)(0.051)+(1/1.45)(0.1470) {/eq}

{eq}WACC = 11.72\% {/eq}

WACC Division X Division Y
11.72% 11.72%+0.5%=11.22% 11.72%+1%=12.72%

Since Division X provides a rate of return of 11.64% which is greater than the required rate of return of 11.22%, therefore, in case of Division X, the new project yields positive NPV and adds value to the company. While Division Y provides a rate of return of 12.30% which is less than the required rate of return of 12.72%, therefore, the new project does not yield value to the company.

Thus, the company should accept Division X's project while rejecting Division Y's project.


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Divisional Cost of Capital

from Finance 101: Principles of Finance

Chapter 14 / Lesson 6
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