Question

Nihau Tech has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 11%. The CFO, Ms Chen, believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO, Mr. Wu, disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If Mr. Wu's position is accepted, what is likely to happen over time?

a) The company will take on too many high-risk projects and reject too many low-risk projects.

b) The company's overall WACC should decrease over time because its stock price should be increasing.

c) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.

d) The company will take on too many low-risk projects and reject too many high-risk projects.

Answer 1

ANSWER :

Option (a) : The company will take on many high-risk projects and reject too many low-risk projects.

High risk projects’ expected earnings  need to be discounted at higher than the overall WACC of 11%. 

However, they will be discounted at 11% rate only.  Hence, these projects will get over valued and accepted and thus the company will take on many high-risk projects.

In case of low-risk projects the opposite will happen. These projects will be discounted at 11% while lower risk-adjusted rate should have been applied. So, this projects will get under  valued and get rejected. Hence, too many low-risk projects will get rejected.

Answer 2

a) The company will take on too many high-risk projects and reject too many low-risk projects