Question
If a firm has two divisions and one division is riskier than the other, what would be the potential result if the firm used its overall WACC to evaluate the projects in both divisions?
Multiple choice question.
Both divisions will receive the correct amount of funding because all projects will be correctly accepted or rejected.
The less risky division’s projects will typically receive full funding and the riskier division’s projects will often be incorrectly rejected.
The riskier division’s projects will typically receive full funding and the less risky division’s projects will often be incorrectly rejected.
Both divisions will receive the incorrect amount of funding because all projects will be incorrectly accepted or rejected.
Multiple choice question.
Both divisions will receive the correct amount of funding because all projects will be correctly accepted or rejected.
The less risky division’s projects will typically receive full funding and the riskier division’s projects will often be incorrectly rejected.
The riskier division’s projects will typically receive full funding and the less risky division’s projects will often be incorrectly rejected.
Both divisions will receive the incorrect amount of funding because all projects will be incorrectly accepted or rejected.
Answers
GPT-4o mini
The correct answer is:
**The less risky division’s projects will typically receive full funding and the riskier division’s projects will often be incorrectly rejected.**
Using the overall Weighted Average Cost of Capital (WACC) for both divisions means that the riskier division (which should have a higher discount rate to reflect its higher risk) may have its projects undervalued, leading to the rejection of potentially beneficial projects, while the less risky division may have its projects overvalued, resulting in a higher likelihood of acceptance for projects that may not generate acceptable returns relative to their risk.
**The less risky division’s projects will typically receive full funding and the riskier division’s projects will often be incorrectly rejected.**
Using the overall Weighted Average Cost of Capital (WACC) for both divisions means that the riskier division (which should have a higher discount rate to reflect its higher risk) may have its projects undervalued, leading to the rejection of potentially beneficial projects, while the less risky division may have its projects overvalued, resulting in a higher likelihood of acceptance for projects that may not generate acceptable returns relative to their risk.