Question

Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)? Suppose a firm estimates its weighted average cost of capital (WACC) to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average, high and low-risk projects?

Answer 1

ANSWER :

Firms usually use equity and debt and in some cases preference equity also,   to raise its capital. Debts alone as a source of capital is highly risky. If company’s earnings do not match ori is lower than the cost of debt than the firm’s survival will be at risk.It may go out of business and may get liquidated. Equity alone may be costlier as cost of equity is usually higher than the debt. A part of capital from debt gives advantage of tax savings and lowers the actual cost of debt.

As sources of capital are more than one, overall cost of capital based on weights of capital type termed as WACC needed to be used. 

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.