Smith and Jones has two separate divisions. Division X produces custom work on a pre-paid basis only for long-term customers and therefore, is subject to less risk than division Y. The company has assigned a discount rate equal to the firm's WACC minus 2 percent to division X and a rate equal to the firm's WACC plus 3 percent to division Y. The company has a debt-equity ratio of .65 and a tax rate of 35 percent. The cost of equity is 9 percent and the aftertax cost of debt is 5 percent. Presently, each division is considering a new project. Division Y's project provides a 9.5 percent rate of return and division X's project provides a 6.2 percent return. Which projects, if either, should the company accept?
a. accept both X and Y
b. accept X and reject Y
c. reject X and accept Y
d. reject both X and Y
e. The answer cannot be determined without additional information.
2 answers