Question

7. Factors that affect the cost of capital equation

Each of the following factors affects the weighted average cost of capital (WACC) equation. Which of the following factors are outside a firm’s control? Check all that apply.

Interest rates in the economy

The performance of index funds, such as the S&P 500

The firm’s dividend payout ratio

The impact of a firm’s cost of capital on managerial decisions

Consider the following case:

National Petroleum Refiners Corporation (NPR) 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 L is considering a project with an expected return of 9.5%.

Should National Petroleum Refiners Corporation (NPR) accept or reject the project?

Accept the project

Reject the project

On what grounds do you base your accept–reject decision?

Division L’s project should be accepted, because its return is less than the risk-based cost of capital for the division.

Division L’s project should be accepted, since its return is greater than the risk-based cost of capital for the division.

Answer 1

Yes each of the factors affect the Wacc and those factors which are out of control of the firm is

a)Interest rate in economy

b)The performance of index fund.

as both of the factors are directly connected to economy and country in which the firm is operation as and firm cannot change or influence any of the factors from a firm level where as the other two factor like the firm dividend payout ratio and the firm's cost of capital on managerial decision can be changes at the firm level as these factors are in hand of firm.

and next question's answer

Division L's project should be accepted, since its return is greater than the risk based cost of capital for the division.

As the return from this division is 9.5% and risk based cost of capital for the division is only 8%.

which means this division is giving 1.5% more than the required rate of return therefore this project l should be accepted.