Question

is always correct to use WACC as the discount rate ? explain

Answer 1

WACC measures the weighted average cost of the fund that is to be used for investment in a new Project. The future cash flows are discounted by using the WACC rate to get the present value of the cash flows and to measure the NPV.

WACC calculates the weighted average cost considering the gearing of the capital structure . However , ther is always a project risk for every new project on various grounds like technological challenges, marketing uncertainties, Product obsolescence, interest rate fluctuations, Cash flow uncertainties, length of project etc which are unique to every project.

Therefore in case of risky projects a risk premium is added to WACC to get a risk adjusted WACC as a discount factor which gives a more justified NPV result.

Therefore , WACC may be used for projects having no additional risk , but for projects with substantial risk, the risk adjsuted discount factor is uised.