Question

Suppose a firm estimates its 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?

Answer 1

Yes, Weighted Average Cost of Capital should be used to evaluate the potential projects. A project requires an initial investment of certain amount of money and it will be getting some income over a time period. The company will have to ensure that they invest their money in such projects only which are beneficial to them . In other words, the project should be chosen such that the inflows from the project are more than the outflows or the initial investment of the project.

A company raises money or capital from a variety of sources like debt, equity, preference capital etc. A weighted average of the cost of these sources of capital is considered as the WACC of the company. It is the minimum rate of return that the firm expects from any project. So, WACC is needed to compare the rate of return of any project. It helps in evaluating and deciding whether a project should be accepted or rejected.

If rate of return > WACC then accept the project as the risk is less

If rate of return < WACC then reject the project as the risk is high