Question

Why do we use the overall cost of capital for investment decisions even when only one source of capital will be used (e.g., debt)? Suppose a firm estimates its weighted average cost of capital (WACC) to be 10%. Should the WACC be used to evaluate all of its potential projects, even if they vary in risk? If not, what might be “reasonable” costs of capital for average, high and low-risk projects?

(150 words at least)

Answer 1

No firm can be entirely funded with debt as creditors insist on minimum equity before funding. This means that even though a particular project may be funded entirely with debt the corporate balance sheet also has the equity component. The cost of capital for the firm would thus be the weighted average cost of capital of debt and equity.

WACC cannot be explicitly used for all projects having varying risks because each projects risks would value the project differently. Using WACC across all projects would result in overvaluation for higher risk projects and undervaluation for high risk projects.

For those projects with average risk, the WACC of 10% can be used. For those projects with high risk, WACC > 10% need to be used depending on the risk and the risk premium that can be assigned. For those projects having lower risk, WACC < 10% need to be used in accordance with the negative risk premium for the project.