Answer to Question #6262 in Economics of Enterprise for Jacqueline Davis

Question #6262
Cranberry Corp. has two divisions of equal size: a computer manufacturing division and a data processing division. Its CFO believes that stand-alone data processor companies typically have a WACC of 8%, while stand-alone computer manufacturers typically have a 12% WACC. He also believes that the data processing and manufacturing divisions have the same risk as their typical peers. Consequently, he estimates that the composite, or corporate, WACC is 10%. Which of the following statements is CORRECT?
a. While the decision to use just one WACC will result in its accepting more projects in the manufacturing division and fewer projects in its data processing division than if it followed the consultant’s recommendation, this should not affect the firm’s intrinsic value.
b. The decision not to adjust for risk means, in effect, that it is favoring the data processing division. c. The decision not to adjust for for risk means that the company will accept too many projects in the manufacturing division and too
Expert's answer
Statement C is CORRECT. As we know the WACC is the minimum return that a company
must earn on an existing asset base to satisfy its creditors, owners, and other
providers of capital, or they will invest elsewhere. In this case on data
processing and manufacturing divisions. If not to adjust the risk the company
will increase the manufacturing division projects because of higher WACC.
Moreover intrinsic value will being reduced because it depends on quantitative
factor as capital, for instance, thus on WACC, and qualitative as competitive
advantage, for example. But without risk-adjusted decision we don't have the
information on qualitative factors. But risk-adjusted return on capital as the
average of the costs of these sources of financing will help to determine how
much interest the company has to pay for each monetary unit it finances.

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