Q#2 (chapter 9). a diversified company has decided to use its overall firm wacc as a performance benchmark for rating its divisional managers and to decide whether new projects from its three divisions should be funded for investment capital. the firm wacc is 12%. the divisional waccs for its high risk, average risk, and low risk divisions are 16%, 11.9%, and 8%, respectively. explain the pros and cons of using the firm wacc in evaluating its divisional managers and projects. remember that wacc can be interpreted as a hurdle rate or the minimum acceptable return. limit your answers to 10 sentences.

Pros: Use of singe hurdle rate saves time in the evaluation of projects which results in prompt decision making.

Cons: Company may reject good projects and accept bad ones due to the assumptions underlying WACC use in capital budgeting.

Explanation:

Pros of using WACC: The use of WACC implies that the company  uses a single hurdle rate  for all projects, which simplifies the decision making and saves  time when evaluating projects

Cons of using WACC: Use of WACC assumes that  there is no change in capital structure i.e all projects are financed in exactly the same way and all projects have the same risk . These assumptions  may lead to the company rejecting good projects  and accepting bad ones. For example the company may accept a high risk project with a return of 14% when the minimum return that should be accepted according to the high risk divisional WACC is 16%. Likewise, the company may reject a low risk project with a return of 11%, when it is in fact a good project whose minimum return should be 8% as per the low risk divisional WACC.

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