[thetoddgreen]

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?

It said the correct answer was:
High‐risk divisions will over‐invest in new projects and low‐risk divisions will under‐invest in new projects.

While my answer was:
Low‐risk divisions will over‐invest in new projects and high‐risk divisions will under‐invest in new projects.

This alone makes me scratch my head because that goes against logic… However, after reading their explanation, it appears as if their explanation further states how my answer is actually correct, rather than the opposite answer – so I scratch my head more. I have provided their explanation below in case any of you agree with me and are curious. However, regardless of that – I am more concerned on understanding this concept 🙁

The use of a company‐wide cost of capital to evaluate new capital investments will not result in low‐risk divisions over‐investing in new projects and high‐risk divisions under‐investing in new projects, rather high‐risk divisions will over‐invest in new projects and low‐risk divisions will under‐invest in new projects. Because the company has multiple operating divisions, each having unique risk attributes and related capital costs, the use of a company‐wide cost of capital to evaluate new capital investments applies a common, average hurdle rate to all projects, regardless of the risk or cost of capital of the particular division for which the capital investment is being considered. Thus, for example, a high‐risk division will use the company‐wide average cost of capital that will be less than the cost of capital appropriate for its risk and separate cost of capital. Similarly, a low‐risk division will use a cost of capital that is greater than the cost of capital appropriate for its risk and separate cost of capital.

[thetoddgreen]

Nevermind… You want to invest more in low risk because it costs less, and invest less in high risk because it costs more. I had to go back and think about it as per LT debt vs stocks. I tried to delete this but it won't let me. Ignore me! It has been a day

[fragchild]

Both the answer and explanation are correct. This is more related to finance. A key principle to remember is that for higher risk, investors need to be compensated with higher returns.

Let's take a simple example, a higher risk division has a cost of capital of 10%, while a lower risk division has a cost of capital of 5% (remember: higher risk has higher cost of capital, lower risk has lower cost of capital).

The weighted cost of capital (WACC) (if weighting is equal) will be 7.5%. Since we are using WACC of 7.5% instead of actual risk, for a higher risk division, we are assuming less risk (i.e. risk of 7.5% instead of actual risk of 10%) while for a lower risk division, we are assuming a higher risk (i.e. risk of 7.5% instead of actual risk of 5%). Because our calculations assume risk of 7.5% for high risk division, we are likely to over-invest. Equally our calculations assume risk of 7.5% for low risk division, therefore we are likely to under-invest.

[Amortized and Energized]

Yes, to echo your sentiment the higher risk project should also come with a higher risk/cost of capital than the lower risk project, so individually they would have different costs of capitals associated with them. When you apply the weighted average, you are making the higher risk look more appealing because the higher CoC you'd expect to see with it is being decreased by being averaged in with lower risk projects and vice versa for the low risk project looking less appealing because it's CoC is being increased by being averaged with higher risk projects.

Good luck on BEC!! I actually enjoyed that test the most which runs opposite to others' sentiment on the site :-). I was a finance major though, not accounting.

FAR - Aug 2015 (58), Feb 2016 (81)
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BEC - May 2016 (79)
AUD - Jul 2016
REG - Aug 2016

[Author]

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