Question

Why would a firm not use its weighted average cost of capital (WACC) to evaluate all proposed investments? Hints and notes to students: dot points are acceptable. It is important to explain your answers with details or demonstrate your understanding by applying examples. Full marks will not be awarded to identical (100% similarity) answers from the required textbook. Please this answer should not be same as answers here. thank you.

Answer 1

The weighted average cost of capital of a firm is the required return on the existing projects of the firm. It represents the weighted average of the returns expected by the stockholders and debt holders of the firm for the risk associated with the existing projects of the firm.

When a firm embarks upon new projects having risk/return characteristics similar to existing businesses, then WACC is the appropriate discount rate. But, when the risk/return characteristics of the new businesses are different from that of the existing ones, then adjustment to the WACC needs to be done to reflect the risk associated with the new project. The WACC could be decreased or increased to suit the riskiness of the new business in comparison with the existing ones.