A Diversified Company Has Decided To Use Its Overall Firm Wa

A Diversified Company Has Decided To Use Its Overall Firm Wacc As a Pe

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. Please 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 no more than 10 sentences.

Paper For Above instruction

Using the overall firm WACC of 12% as a benchmark to evaluate divisional managers and projects in a diversified company presents both advantages and disadvantages. On the positive side, employing a single weighted average cost of capital simplifies performance assessment and capital allocation by providing a consistent hurdle rate across divisions, facilitating managerial comparisons and decision-making. It also streamlines the evaluation process, especially when divisional risk levels are comparable or management prefers a uniform standard. However, a significant drawback is that the firm WACC does not account for the specific risk profiles of individual divisions; high-risk divisions may be unfairly evaluated using a lower threshold, leading to potential misallocation of resources, while low-risk divisions might be unduly penalized. For a high-risk division with a WACC of 16%, using the firm’s 12% WACC underestimates the true risk-adjusted return requirement, risking underinvestment. Conversely, for a low-risk division with an 8% WACC, the firm WACC may be too high, discouraging investment in projects that meet their actual risk-adjusted hurdle. Relying solely on the firm WACC can lead to suboptimal decisions that do not reflect division-specific risk, potentially misaligning incentives and performance measurement. It also ignores the opportunity costs of deploying capital in divisions with different risk-return trade-offs. Furthermore, this approach could result in the funding of underperforming projects in riskier divisions or the rejection of worthwhile investments in safer divisions. To improve evaluation accuracy, it is advisable for firms to consider division-specific WACCs or risk-adjusted hurdle rates, aligning performance metrics with each division’s unique risk profile. Ultimately, the appropriateness of using the firm WACC hinges on the company’s risk management policies and strategic priorities, but it generally oversimplifies the complex risk environment across divisions.

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