Question

Swizer Industries has two separate divisions. Division X has less risk so its projects are assigned a discount rate equal to the firm's WACC minus 0.5 percent. Division Y has more risk and its projects are assigned a rate equal to the firm's WACC plus 1 percent. The company has a debt-equity ratio of 0.45 and a tax rate of 35 percent. The cost of equity is 14.7 percent and the aftertax cost of debt is 5.1 percent. Presently, each division is considering a new project. Division Y's project provides a 12.3 percent rate of return and Division X's project provides an 11.64 percent return. Which projects, if any, should the company accept

Answer 1

Answer:

B. Accept X and reject Y

Explanation:

Here are the options

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 based on the information provided

the project should be accepted if the WACC of the department is less than the rate of return on the project

WACC = weight of equity x cost of equity + weight of debt x after tax cost of debt  

weight of debt = D / (D + E) = 0.45E /1.45E

weight of equity = E / (D + E) = E / 1.45E

WACC = ( 0.45E /1.45E) x (5.1)  + ( E / 1.45E) x 14.7

= 5.1 x (0.45/1.45)  + 14.7 x (1/1.45)

=1.583 + 10.138

11.72%

Division X's WACC = 11.72% - 0.5% = 11.22%

Division Y's WACC = 11.72% + 1% = 12.72%

The rate of return of Division Y's project is 12.3%. Thus, division Y's project should not be accepted

the rate of return of Division X's project is 11.64%. Thus, division X's project should be accepted