Swizer Industries has two separate divisions. Division X has less risk so its projects are assigned a discount rate equal to the firm's WACC minus 0.5 percent. Division Y has more risk and its projects are assigned a rate equal to the firm's WACC plus 1 percent. The company has a debt-equity ratio of .45 and a tax rate of 35 percent. The cost of equity is 14.7 percent and the after-tax cost of debt is 5.1 percent. Presently, each division is considering a new project. Division Y's project provides a 12.3 percent rate of return and division X's project provides an 11.64 percent return. Which projects, if any, should the company accept?A. Accept both X and YB. Accept X and reject YC. Reject X and accept YD. Reject both X and YE. The answer cannot be determined based on the information provided

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cancinodavidq cancinodavidq · Answer 1 · 2019-12-09T21:04:55+01:00

Answer:

So Correct answer is B. Accept X and reject Y

Explanation:

We know WACC = Kd*(1-T)*Wd + Ks*Ws where Ws&Wd are weights of Equity & Debt, Kd & Ks are Before Tax cost of Debt & Cost of equity.

We also have D/E = 0.45 or D=0.45*E

Tax Rate T=35%, Ks=14.7%, Kd(1-T) =5.1%

We can also write WACC eqn as

WACC = Kd*(1-T)*(D/(D+E)) + Ks*(E/(D+E))

ie WACC = 5.1%*(0.45E/1.45E) + 14.7%*(E/1.45E)

ie WACC = 5.1%*(0.45/1.45) + 14.7%*(1/1.45)

ie WACC = 11.72%

Acceptance criteria :

We will accept the Project if the Return is more than WACC i Return > WACC

DIvision X Disc Rate = WACC-0.5% = 11.72% -0.5% = 11.22%,

For Div X, Return from New proj is 12.3%. So Return>WACC....SO Accept this Project.

DIv Y Disc Rate = WACC+1% = 11.72%+1% = 12.72%

For Div y, Return from New proj is 11.64%. SO Return< WACC. SO Reject this proj.

So Correct answer is B. Accept X and reject Y