Final answer:
The comparison between firmwide WACC and a subjective divisional WACC revolves around the standardization of risk assessment versus tailored risk assessment for individual projects. A subjective approach may be more suitable for projects with risk profiles that are significantly different from the company's average. This customization enables a more accurate evaluation of the project's potential and aligns the cost of capital with its specific risk.
Step-by-step explanation:
When companies assess the cost of capital for new projects, they may use a firmwide Weighted Average Cost of Capital (WACC) or a divisional or project-specific WACC, which might be influenced more subjectively. The firmwide WACC is a single, comprehensive cost of capital that applies to the entire organization and is used to evaluate all projects regardless of their risk or division. However, not all projects have the same risk level, which is where a subjective approach to forming divisional WACC comes in. This approach adjusts for project-specific risks, potentially leading to more accurate assessments of a project's viability.
A subjective approach to WACC might be more appropriate when projects differ significantly in terms of risk from the company's average risk profile. High-risk projects might warrant a higher WACC to account for the potential for higher returns needed to compensate for that risk. Conversely, lower-risk projects might be evaluated with a lower WACC, acknowledging their more stable nature. This approach also allows a more tailored analysis relative to the one-size-fits-all firmwide WACC.
Overall, while the firmwide WACC provides a standardized benchmark, the subjective divisional approach better accounts for variations in project risk, potentially leading to more appropriate investment decisions.