324 Part 4 Investing in Long-Term Assets: Capital Budgeting
and if it were operated as a separate! rm, its WACC would be 7%. Division H has
higher risk, and its divisional cost of capital is 13%. Since the two divisions are of
equal size, Firm A’s composite WACC is calculated as 0.50(7%) + 0.50(13%) = 10%.
However, it would be a mistake to use this 10% WACC for either division. To see
this point, assume that Division L is considering a relatively low-risk project with
an expected return of 9%, while Division H is considering a higher-risk project
with an expected return of 11%. As shown in Figure 10-2, Division L’s project
should be accepted because its return is above its risk-based cost of capital,
whereas Division H’s project should be rejected. If the 10% corporate WACC was
used by each division, the decision would be reversed: Division H would incor-
rectly accept its project, and Division L would incorrectly reject its project. In gen-
eral, failing to adjust for differences in risk would lead the! rm to accept too
many risky projects and reject too many safe ones. Over time, the! rm would
become riskier, its WACC would increase, and its shareholder value would suffer.
We will return to these issues in Chapter 12, when we consider different approaches
for measuring project risk.Risk and the Cost of Capital
F I G U R E 1 0! 1RiskL RiskA RiskH Risk8.010.012.0Firm L’s WACCFirm A’s WACCFirm H’s WACCWACCAcceptance RegionRejection Region0Rate of Return
(%)SELF^ TEST Why is the cost of capital sometimes referred to as a “hurdle rate”?
How should! rms evaluate projects with di" erent risks?
Should all divisions within the same! rm use the! rm’s composite WACC for
evaluating all capital budgeting projects? Explain.