Question

What would happen if we use the WACC for all projects regardless of risk?

Assume the WACC = 15%

Project             Required Return             IRR

A                                  20%                           17%

B                                  15%                           18%

C                                  10%                           12%

Which projects would be accepted if they used the WACC for the discount rate? Explain why.

Which projects should be accepted if you use the required return based on the risk of the project? Explain why.

Answer 1

Projects A and B would be accepted if we only used WACC for the discount rate, as the cashflows for project A and project B would be positive given a higher IRR than 15%, that is, 17% and 18% respectively.

Using the WACC as our discount rate is only appropriate for projects that are the same risk as the firm’s current operations. If we are looking at a project that is NOT the same risk as the firm, then we need to determine the appropriate discount rate for that project.
Selecting the project based on:
# pureplay approach:

>Find one or more companies that specialize in the product or service that we are considering
>Compute the beta for each company
>Take an average
>Use that beta along with the CAPM to find the appropriate return for a project of that risk

#Subjective approach:
>Consider the project’s risk relative to the firm overall
>If the project is more risky than the firm, use a discount rate greater than the WACC
>If the project is less risky than the firm, use a discount rate less than the WACC
>You may still accept projects that you shouldn’t and reject projects you should accept, but your error rate should be lower than not considering differential risk at all
Different discount rates can be used by a subjective approach in the following manner:

Risk Level	Discount Rate
Very Low Risk	WACC – 8%
Low Risk	WACC – 3%
Same Risk as Firm	WACC
High Risk	WACC + 5%
Very High Risk	WACC + 10%

based on the risk of the project, project B and C would be selected otherwise the firm will become risky