Question

Why would a firm not use its weighted average cost of capital (WACC) to evaluate all proposed investments? Please give examples as well

Under what circumstances will the IRR and NPV rules lead to the same decision (accept/reject)? When might they conflict? Please give examples as well

Answer 1

1). A firm would not use its weighted average cost of capital (WACC) to evaluate all proposed investments because:

WACC represents the required return of a firm. But sometimes the proposed investment’s risk might be different from that of 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 riskier 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, historical data is used. Dividend per share of the past years is used to find the growth rate which is used to calculate cost of equity. It may not hold well during the life of the proposed investment. Hence WACC cannot be used in such situations.

WACC is based on the assumption of no change in capital structure. It does not hold well when the capital structure is changed during the life of the proposed investment.

The capital structure of the proposed investment might be different from that of the firm. For example in case of projects where project specific finance is used, the project might be more geared than the firm as whole. In such cases it would be inappropriate to use the WACC of the firm.

2). Same decision:

1. Project’s cash flow must be conventional- the initial cash flow is negative and all the rest are positive

2. Project must be independent- the decision does not affect other decision.

Conflict:

1. The cash flows are not conventional- multiple rate of return( more than one discount rate makes the NPV of an investment zero)

2. Compare two or more investment- mutually exclusive investment decisions, the investment with the highest NPV depends on our required return.