Question

1. Suppose the firm estimates its WACC to be 10%.

(A) Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? Explain.

(B) Would the NPVs change if the WACC changed? Explain.

Answer 1

ANSWER :

(A) 

WACC estimated by the company should not be applied to evaluate all projects irrespective of risks involved. For average risk projects, estimated WACC can be applied. For high risk and low risk projects risk-adjusted WACC should be applied.

Risk-adjusted WACC can be calculate based on beta of similar projects and then required return rate can be calculated using CAPM model. This rate will be risk-adjusted WACC for use in evaluating the projects in accordance of their risks.

For high risk projects, beta will be higher and correspondingly adjusted WACC will be higher than the normal one. Similarly low risk project will have lower beta and lower adjusted WACC. 

This approach would be more realistic and avoid over or under valuation of the projects.

(B)

NPV will change if WACC is changed, since all the future expected earnings will be discounted at the changed WACC. A higher WACC will lower the NPV and a lower WACC will raise the NPV. 

Answer 2

A) WACC is Cost of capital
So If NPV is Positive & IRR is greater than WACC, the project is acceptable.
If NPV Is negative, Project is risky & should not be taken even if IRR is high.

Would the NPVs change if the WACC changed? Explain.

The NPV always depends on the WACC. If the cost of capital changes, NPV would also change. There is a direct relation betweenthe NPV and WACC. Increased cost of capital leads to higher NPV and decrease cost of capital obviously leads to lower NPV.