Essentials Of Investments
11th Edition
ISBN:9781260013924
Author:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Publisher:Bodie, Zvi, Kane, Alex, MARCUS, Alan J.
Chapter1: Investments: Background And Issues
Section: Chapter Questions
Problem 1PS
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Question
7. Factors that affect the cost of capital equation
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.
Tax rate
The inflation rate
The firm’s dividend payout ratio
The impact of 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 H is considering a project with an expected return of 12%.
Should Lancashire Railway Company (LRC) accept or reject the project?
a Accept the project
b Reject the project
On what grounds do you base your accept–reject decision?
Division H’s project should be rejected since its return is less than the risk-based cost of capital for the division.
aDivision H’s project should be accepted, as its return is greater than the brisk-based cost of capital for the division.
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