Question

Suppose a firms estimates its WACC to be 15%. Should the WACC be used to evaluate all of its potential projects, even it they vary in risk? If not, what might be "reasonable" costs of capital for average-, high-, and low-risk projects?

Answer 1

ANSWER :

First Part :

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.

Second Part :

Cost of equity as per CAPM model :

= risk-free rate + beta * (return on market - risk-free rate)

= 3.20 + 0.86 (15.75 - 3.20)

= 13.99 % (ANSWER).

Answer 2

As per CAPM

Cost of Equity = Risk free rate + Beta (Return on Market - Risk free rate)

= 3.20% + 0.86(15.75%-3.20%)

Cost of Equity = 13.99%