Question

Puckett Inc. risk-adjusts its WACC to account for project risk. It uses a risk-adjusted project cost of capital of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Puckett accept, assuming that the company uses the NPV method when choosing projects?

a. Project C, which has above-average risk and an IRR = 11%.

b. Without information about the projects' NPVs we cannot determine which project(s) should be accepted.

c. Project B, which has below-average risk and an IRR = 8.5%.

d. All of these projects should be accepted.

e. Project A, which has average risk and an IRR = 9%.

Answer 1

Answer is “Project B, which has below-average risk and an IRR = 8.5%”

Company is analyzing three independent projects; therefore, decision under NPV method and IRR method will be same.
Company should accept project whose IRR is higher than its risk-adjusted WACC for that project.

Project A:

Risk Adjusted WACC = 10%
Internal Rate of Return = 9%

Therefore, company should reject Project A its IRR is less than WACC

Project B:

Risk Adjusted WACC = 8%
Internal Rate of Return = 8.5%

Therefore, company should accept Project B its IRR is greater than WACC

Project C:

Risk Adjusted WACC = 12%
Internal Rate of Return = 11%

Therefore, company should reject Project C its IRR is less than WACC