Question

Lapango Inc. estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 8%, and its above-average risk project: have a WACC of 12%. Which of the following project(s) should the company accept with the features of each project being described as follows? (Hint: No calculation is needed) A) Accept Project a, if Project a is of average risk and has a return of 11%. B) Accept Project b, if Project b is of below-average risk and has a return of 7.5%. O C) Accept Project c, if Project of c is above-average risk and has a return of 11.5%. D) ALL of Projects a, b, and c stated above should be accepted. OE) NONE of Projects a, b, and c stated above should be accepted.

Answer 1

1)

Projects should be accepted if the return > Cost of capital (ie WACC). In the above example, as a has an average risk (ie WACC = 8%) and return (11%) > WACC, a should be accepted. All other projects have WACC > Return.

Answer is A)

2)

Cumulative cash flows in year 1 = -500 + 150 = -350

Cumulative cash flows in Year 2 = -350 + 200 = -150

Cumulative cash flows in Year 3 = -150 + 600 = 450

Regular payback = 2 + (150/600) = 2.25 years

Answer is C) 2.25 years