Question

Why would a firm not use its weighted average cost of capital (WACC) to evaluate all proposed investments? (5m)

Hints and notes to students: dot points are acceptable. It is important to explain your answers with details or demonstrate your understanding by applying examples. Full marks will not be awarded to identical (100% similarity) answers from the required textbook.  

Answer 1

A firm may not use its WACC to evaluate all of its proposed investments because the WACC is always a representation of the firm’s required rate of return whereas the proposed investment at times may have a different risk when compared with the firm as a whole.

For example, If a pharmaceutical firm which is into manufacturing of generic medicines is proposed to venture into new line of medicines based on R&D, then it cannot use WACC. Because R&D is more risky than the manufacture of generic medicine. The rate used for the proposed project should be in premium when compared to WACC.

WACC is based on market values of capital that keep on changing. Thus WACC will transform over time. However when it is used in evaluating the proposed investment, it is assumed to remain constant during the economic life of the project. This assumption doesn’t hold good in real life scenarios. Hence it not appropriate to use WACC.

Also, in order to calculate the Cost of equity to eventually arrive at WACC,