What are the implications for a firm's capital investment decisions of using a company-wide cost of capital

Question

when the firm has multiple operating divisions that have unique risk attributes and capital costs?

What will be an ideal response?

Answer 1

Firms that have multiple operating divisions where each division's risk is unique and different from that of the firm as
a whole often use different costs of capital for each division in an effort to properly account for risk. The idea here is
that the divisions take on investment projects with unique levels of risk and, consequently, the WACC used in each
division is potentially unique to that division. Generally, divisions are defined either by geographical regions (for
example, the Latin American division) or industry (for example, exploration and production, pipelines, and refining
for a large integrated oil company).
The advantages of using a divisional WACC include the following:
• It provides different discount rates that reflect differences in the systematic risk of the projects evaluated by the
different divisions.
• It entails only one cost of capital estimate per division (as opposed to unique discount rates for each project), thereby
minimizing the time and effort of estimating the cost of capital.
• The use of a common discount rate throughout the division limits managerial latitude and the attendant influence
costs, as managers would otherwise be tempted to lobby for a lower cost of capital for pet projects.