Question

Old Town Industries has three divisions. Division X has been in existence the longest and has the most stable sales. Division Y has been in existence for five years and is slightly less risky than the overall firm. Division Z is the research and development side of the business. When allocating funds, the firm should probably:

Answer 1

Answer:

D) assign the highest cost of capital to Division Z because it is most likely the riskiest of the three divisions.

Explanation:

When a corporation's business units clearly have differentiated risks associated to their activities, the corporation can assign different capital structures to each division and if possible calculate their own weighted average cost of capital (WACC).

One of the basic premises in business, is that investors are risk adverse. This means that investors will require higher returns from riskier investments. WACC has two main components: shareholder equity and debt (either loans, bonds, preferred stock). Debt should cost the same for every division, but shareholder equity shouldn't.

It is the same reason why a subsidiary that operates in Australia has a lower WACC than a subsidiary operating in South America, and that one has a lower WACC than a subsidiary operating in Africa. Higher risk always demands higher returns.

Answer 2

Answer:

D.

Explanation:

Based on the scenario being described within the question it can be said that when allocating funds, the firm should probably assign the highest cost of capital to division Z because it is most likely the riskiest of the three divisions. This is because Division Z focuses on research and development which means that they might not actually discover or create something that can bring value to the company and is therefore highly risky.