Question

1. Company A and Company B are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in A having a WACC of 12% and B a 15% WACC. A is considering Project X, which has an IRR of 11.5% and is of the same risk as a typical company A project. B is considering Project Y, which has an IRR of 16.5% and is of the same risk as a typical Company B project.

Now assume that the two companies merge and form a new company, ANB. Moreover, the new company’s market risk is an average of the premerger companies’ market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y.

For each of the following statements, identify whether it is a CORRECT statement OR NOT and explain why (there will be no mark if an answer is not explained, or wrongly explained):

a) Project X would have a negative NPV if it is evaluated using the correct post-merger WACC. (10%) [4 Marks]

b) If the firm evaluates these projects and all other projects at the new overall corporate WACC, which project will be overvalued (when estimated value is greater than its true value)? [6 Marks]

c) Discuss the advantage and disadvantage of using new overall corporate WACC instead of using their original WACC before the merging event

Answer 1

(a) Company A and Company B have WACC's of 12 % and 15 % respectively. The two companies merge to form an entity ANB which has market risk equal to the average of the two merging companies market risk. Project X and Y are not impacted by the merger in any way though.

ANB's WACC = Average of Company A and Company B's WACC = 12 + 15 / 2 = 13.5 %

Correct Post Merger WACC for Project X should be 12 % and not 13.5 % because the merger does not impact Project X's risk and the same continues to be equal to Company A's pre-merger project risks. As Project X's appropriate WACC of 12% is greater than the Project's IRR of 11.5 %, the Project's NPV would be negative if discounted at 12 %.

Hence, this option is CORRECT.

(b) The underlying idea behind solving this question would involve identifying the fact that even post-merger the risk-appropriate WACC for Project X continues to be 12% (equal to Company A's pre-merger WACC) and for Project Y continues to be 15 % (equal to Company B's pre-merger WACC) as the merger leaves the Projects' risk levels unaltered.

If Project X is evaluated using the post-merger WACC of 13.5 % instead of the risk-appropriate 12 %, the Project's Cash Flows would be discounted to a greater extent than required. This, in turn, would undervalue the project. Similarly, if Project Y is evaluated using the post-merger WACC of 13.5 % instead of the risk-appropriate 15 %, the Project's Cash Flows would be discounted to a lesser extent than required. This, in turn, would overvalue the project.

(c) The advantage of using the new WACC is avoiding the cumbersome hassle of determining a WACC for every new and old project that the merged entity undertakes. It also brings about a much-required standardization in terms of risk levels and valuation. The disadvantage is that if the overall WACC is not commensurate to the risk level of projects being evaluated it would either undervalue or overvalue them.