Factors that affect the cost of capital equation

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

The market risk premium increases

Tax rates

The firms capital structure

The firms capital budgeting decision rules

The impact of cost of capital on managerial decisions

Consider the following case:

Lancashire Railway Company (LRC) has two divisions, L and H. Division L is the companys 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 companys 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 H is considering a project with an expected return of 12%.

Should Lancashire Railway Company (LRC) accept or reject the project?

Reject the project

Accept the project

On what grounds do you base your acceptreject decision?

1. Division Hs project should be rejected since its return is less than the risk-based cost of capital for the division.

2. Division Hs project should be accepted, as its return is greater than the risk-based cost of capital for the division.