6.

What is the danger of using the corporate cost of capital to make investment decisions at the division
level? Give examples of the types of error that could occur.

There are dangers in the use of corporate cost of capital in making decisions at the division
levels. Each division in a multidivisional firm has its own risk therefore considering different investment
opportunities. If a multidivisional firm uses a firm-wide cost of capital, this will result in a systematic
overinvestment in high-risk projects and underinvestment in low-risk projects. This means that projects
that are of high-risk are being accepted, earning as little as the corporate cost of capital even though the
capital market dictates that it should earn more than the firm-wide rate. Thus, risks in different divisions
are not comparable and not the same as the corporate risk.

It is therefore necessary to estimate divisional cut-off rates that will reflect the risk of each
division, by comparing firms that have similar size, nature, and risk to the project to compute the cost of
equity capital. However, it is not assured because finding perfect pure-plays would be impossible.
Comparing the divisions to the other firms total sales and total assets does not guarantee that they
would be of the same size or risk, e.g. total assets are the same but the capital structure of the
comparable firm varies. Moreover, is it not reliable to use total sales as the yard stick in finding
comparable firms because they may differ in cost structure, e.g. distribution of costs in operating,
financing, and administrative.