Question

A firm is considering whether to finance a new project with debt or equity. Will the choice of financing affect the WACC the firm uses to discount the project? Why or why not?

Answer 1

The weighted average cost of capital certainly affects the choice of financing for the firm since it directly increases or decreases the value of the project. If the WACC is higher then the NPV is lesser and vice versa. If the WACC is higher then the NPV is negative which means that the project must not be selected. Usually the WACC is higher if the proportion of equity is higher than the debt since the cost of equity is mostly greater than the cost of debt. As the proportion of equity increases in the capital raised, the WACC increases and the present worth of the project subsequently reduces. However, it does not translate that the company must finance all its projects through debt to attain higher NPV. A right mix between debt and equity must be selected such that the WACC is lower and NPV is also positive.