Question

Marston Manufacturing Company 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 Marston Manufacturing Company accept or reject the project? Reject the project Accept the project On what grounds do you base your accept–reject decision? Division H’s project should be accepted, as its return is greater than the risk-based cost of capital for the division. Division H’s project should be rejected since its return is less than the risk-based cost of capital for the division.

Answer 1

Answer:

Should Marston Manufacturing Company accept or reject the project?

Marston C Company should reject the project because its expected return is lower than Division H's cost of capital.

Since the divisions' risk is so different, and probably their projects are also very different, the company should use different costs of capital to accept of reject the projects based on each division's cost of capital.

Imagine another situation where Division L is evaluating a project that yields 10%. If they used the company's WACC, then they should reject the project, but if they used the division's cost of capital, then they should accept the project (in this case I would recommend accepting it).

Explanation:

Division H's risk = 14%

Division L's risk = 8%

WACC = 11%