[Topsya]

Here is a questions which I found among 2012 AICPA Released Questions and this one is just DRIVING ME NUTS!!!!

Please ANYONE explain it to me in Simple English with some examples….. THANK YOU

23.

A company uses its company-wide cost of capital to evaluate new capital investments. What is the

implication of this policy when the company has multiple operating divisions, each having unique risk

attributes and capital costs?

a. High-risk divisions will over-invest in new projects and low risk divisions will under-invest in new

projects.

b. High-risk divisions will under-invest in high-risk projects.

c. Low-risk divisions will over-invest in low-risk projects.

d. Low-risk divisions will over-invest in new projects and high risk divisions will under-invest in new

projects.

Solution:

Choice “a” is correct. A company-wide cost of capital averages risks to arrive at required return for

investments. The company-wide cost of capital will be lower than the cost of capital specific to high-risk

projects and higher than the cost-of-capital specific to low-risk projects. If a company is comprised of

multiple divisions with unique risk characteristics, higher risk divisions will automatically beat the threshold

for investments and invest in higher risk projects that beat the company wide average. Meanwhile, their

lower risk counterparts will find it hard to achieve the risk return that beats the average (artificially inflated)

returns that are driven by higher risk divisions and will under invest in new projects

AUD - 90
FAR - 83
BEC - 81
REG - 80
ETHICS - 100

[cpame]

Hi! This type of problem deals with NPV and the minimum required rate of return. A diverse company wouldn't want to set just one required rate for the entire firm because some divisions are going to be riskier than others and thus would require a higher rate of return.

I work in the securities industry so it's a little easier to for me to think of these types of problems in terms of stocks and not large capital projects.

So here's my attempt at a coherent example:

If you set a required rate of return (cost of capital) for the entire stock market (company) at say 10%….

Then you would end up purchasing more riskier stocks (start-up companies) because those are the ones that would give you a positive return (NPV)

The lower risk stocks (P&G, GE…) are not going to look very good because it is unlikely they can yield 10% (negative NPV)

But in reality these two groups of stocks are very different and should be evaluated differently. The start-up companies should have a higher required rate of return because they are riskier and the established companies should required a lower rate of return.

The higher the risk then the higher the return needed to invest in the stock or project.

I hope this helped some! I think the example sounded better in my head than on paper

B: 88 2/25/14
A: 81 5/12/14
R: 71, 84
F: 78 10/14/14

[cpame]

Hi! This type of problem deals with NPV and the minimum required rate of return. A diverse company wouldn't want to set just one required rate for the entire firm because some divisions are going to be riskier than others and thus would require a higher rate of return.

I work in the securities industry so it's a little easier to for me to think of these types of problems in terms of stocks and not large capital projects.

So here's my attempt at a coherent example:

If you set a required rate of return (cost of capital) for the entire stock market (company) at say 10%….

Then you would end up purchasing more riskier stocks (start-up companies) because those are the ones that would give you a positive return (NPV)

The lower risk stocks (P&G, GE…) are not going to look very good because it is unlikely they can yield 10% (negative NPV)

But in reality these two groups of stocks are very different and should be evaluated differently. The start-up companies should have a higher required rate of return because they are riskier and the established companies should required a lower rate of return.

The higher the risk then the higher the return needed to invest in the stock or project.

I hope this helped some! I think the example sounded better in my head than on paper

B: 88 2/25/14
A: 81 5/12/14
R: 71, 84
F: 78 10/14/14

[Topsya]

Thank you @grahamk404

AUD - 90
FAR - 83
BEC - 81
REG - 80
ETHICS - 100

[Topsya]

Thank you @grahamk404

AUD - 90
FAR - 83
BEC - 81
REG - 80
ETHICS - 100

[Author]

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