Question

If a firm uses its weighted average cost of capital (WACC) to evaluate all capital budgeting projects, which of the following could occur?

	a.	Projects with little or no risk might be rejected when they actually should be accepted.
	b.	Projects with significant risks might be accepted when the actually should be rejected.
	c.	Projects with average risk will always be rejected when they actually should be rejected.
	d.	All of the above could occur.
	e.	None of the above could occur.

Answer 1

All of the above could occur:

In case of option A, if the firm has high WACC and uses the same WACC for a little or no risk project to discount the cash flows, NPV can be negative and project can be rejected.

In case of option B,  if the firm has low WACC and uses the same WACC for a high risk project to discount the cash flows, NPV can be positive and project can be accepted when they should be rejected.

In case of option C, Projects with average risk will always be rejected when they actually should be rejected