31 3 . Risk-adjusted cost of capital Answer: c Diff: M By Kemp not making the risk adjustment, it is true that the company will accept more projects in the computer division, and fewer projects in the restaurant division. However, this will make the company riskier overall, raising its cost of equity. Investors will discount their cash flows at a higher rate, and the company’s value will fall. In addition, some of the computer projects might not exceed the appropriate risk-adjusted hurdle rate, and will actually be negative NPV projects, further destroying value. Therefore, statement a is false. Because fewer of the restaurant projects will be accepted, the restaurant division will become a smaller part of the overall company. Therefore, statement b is false. As explained above, statement c is true. 32 3 . Risk-adjusted cost of capital Answer: b Diff: M By not risk adjusting the cost of capital, the firm will tend to reject low-risk projects since their returns will be lower than the average cost of capital, and it will take on high-risk projects since their returns will be higher than the average cost of
capital. 33 3 . Risk-adjusted cost of capital Answer: e Diff: M 34 3 . Risk-adjusted cost of capital Answer: a Diff: M 35 3 . Division WACCs and risk Answer: e Diff: M If the company uses the 10 percent WACC, it will turn down all projects with a return of less than 10 percent but more than 8 percent. Thus, these “safer” projects will no longer be taken, and the company will increase the proportion of risky projects it undertakes. Therefore, statement a is true. If Division A’s projects have lower returns than Division B’s because they have less risk, fewer and fewer projects will be accepted from Division A and more projects will be accepted from Division B. Therefore, Division B will grow and Division A will shrink. Therefore, statement b is true. If the company becomes riskier, then its cost of equity will increase causing WACC to increase. Therefore, statement c is true. Because all of the statements are true, the correct choice is statement e. 36 3 . Divisional risk and project selection Answer: e Diff: M N The correct answer is statement e. Statement a is correct; the firms have the same size and capital structure, so the WACC of the merged company is just a simple average of their separate WACCs. Statement b is correct; Project X has an IRR of 10.5% and its appropriate cost of capital is 10%, therefore, the project has a positive net present value. Statement c is also correct; Project X should be accepted because of the previous argument. Project Y should be rejected because it has an 11.5% return and its appropriate cost of capital is 12%. Therefore, statement e is the correct choice. 37 3 . Beta and project risk Answer: a Diff: M 38
3 . Miscellaneous concepts Answer: a Diff: M 39 3 . Cost of new equity Answer: b Diff: E k e = + 5% = 9.94%.
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