Question

The use of WACC as the discount rate to select investments is acceptable when

            A) the correlation of all new projects are equal.

            B) NPV is positive when discounted by the WACC

            C) the risk of the project is equal to the risk of the overall firm.

            D) the firm is well diversified and the unsystematic risk is negligible.

Answer 1

The use of WACC as the discount rate to select investments is acceptable when the risk of the project is equal to the risk of the overall firm.

WACC of a firm is the overall required return by investors on the firm as a whole. It is an indication of risk that is perceived by the investors in that particular firm. Because of this risk indication, if the project under review has risk same as that of firm, WACC of the firm should be used. Else, WACC or discount rate in accordance with risk of that project (relative to risk of firm) should be calculated and used as discount rate for project cashflows assessments.

Higher risk demands higher discount rate/required rate of return and hence higher WACC.  

As such, WACC is often used internally by company directors to determine the economic feasibility of expansionary opportunities and mergers. It is the appropriate discount rate to use for cash flows with risk that is similar to that of the overall firm.