Question

2. Suppose a firm estimates its 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

When the proposed projects vary in risk, the WACC of the firm should be adjusted upwards or downwards, to represent the higher or lower risk of the projects.

The WACC should be used, without adjustment for risk, only if the proposed project has the same risk as the existing business of the firm.

Two methods of adjusting the cost of capital for increased risk are

1] Adjustment based on Coefficient of variation of cash flows of the project:

The WACC can be adjusted if, the COV of the project is above or below a specified value. The adjustment can be a specified number of basis points above or below the WACC.

2] Pure play:

The beta of other companies in the same line of business as the new project can be ascertained and that beta can be adjusted for difference in leverage. The adjusted beta can be used for finding the cost of equity of the project and then the WACC.