Question

If a firm uses its WACC as the discount rate for all of the projects it undertakes then the firm will tend to:

I. reject some positive net present value projects.
II. accept some negative net present value projects.
III. favor high risk projects over low risk projects.
IV. increase its overall level of risk over time.
A. I and III only
B. III and IV only
C. I, II, and III only
D. I, II, and IV only
E. I, II, III, and IV

why choose E

Answer 1

The NPV basis via which the project is accepted/ rejected depends on the Net present values of all the estimated cashflows or returns expected from the project:

In case this NPV> investment on the project = Project is accepted, because this gives an idea that the project will yield profits

else

In case this NPV< investment on the project = Project is accepted

Calculating NPV means discounting all future cashflows arising from the project to account for inflation or changes in value of money.

WACC is weighted average cost of capital of the firm accounting for all categories of capital (equity and debt) weighted proportionately. WACC calculation is inclusive of all sources of capital, including common stock, preferred stock, bonds and any long-term debt owed by the firm.

I. reject some positive net present value projects

II. accept some negative net present value projects.

Fior above 2 options- In case the inflation or decrease in value of money is less, then the NPV of project might be positive. Because WACC takes into account changes in equity ie other investments of the firm to estimate profitability of the firm, it would underestimate the project's profitability

III. favor high risk projects over low risk projects- WACC mainly depends on the proportion of the debt and equity of the firm.

IV. increase its overall level of risk over time- When a a firm’s WACC increases (in cases when beta and rate of return on equity increases), valuation decreases which denotes increase in risk.