Acme Manufacturing Corporation has two divisions L and H Div

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

Solution

(1)

Acme Manufacturing Corporation should accept the project.

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

(2)

Before tax cost of debt = 11.1%

Tax rate = 40%

After tax cost of debt (K_d) = Before tax cost of debt (1 - tax rate)

= 11.1% ( 1 - 0.40)

= 11.1% x 0.60

= 6.6%

Calculation of WACC of Turnbull Co. when equity is raised from retained earnings

Calculation of WACC of Turnbull Co. when new equity is raised

Hence, WACC will increase by10.64% - 9.89% = 0.75% if new equity is raised

Hence, correct option is (d)

(3)

Before tax cost of debt = 9.6%

Tax rate = 40%

After tax cost of debt (K_d) = Before tax cost of debt (1 - tax rate)

= 9.6% ( 1 - 0.40)

= 9.6% x 0.60

= 5.76%

Calculation of WACC of the project

WACC = 9.97%

Source	Cost	Weight	Cost x Weight
Debt	6.6%	0.58	3.8628%
Preferred stock	12.2%	0.06	0.7320%
Common equity	14.7%	0.36	5.2920%
WACC			9.89%