Nihau Tech has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is...

Nihau Tech has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 11%. The CFO, Ms Chen, believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO, Mr. Wu, disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If Mr. Wu's position is accepted, what is likely to happen over time?

a) The company will take on too many high-risk projects and reject too many low-risk projects.

b) The company's overall WACC should decrease over time because its stock price should be increasing.

c) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.

d) The company will take on too many low-risk projects and reject too many high-risk projects.

Solutions

Expert Solution

ANSWER :

Option (a) : The company will take on many high-risk projects and reject too many low-risk projects.

High risk projects’ expected earnings need to be discounted at higher than the overall WACC of 11%.

However, they will be discounted at 11% rate only. Hence, these projects will get over valued and accepted and thus the company will take on many high-risk projects.

In case of low-risk projects the opposite will happen. These projects will be discounted at 11% while lower risk-adjusted rate should have been applied. So, this projects will get under valued and get rejected. Hence, too many low-risk projects will get rejected.

jeff jeffy answered 1 year ago

Next > < Previous

Related Solutions

A firm estimates that its average-risk projects have a WACC of 10%, its below-average risk projects...

A firm estimates that its average-risk projects have a WACC of 10%, its below-average risk projects have a WACC of 9%, and its above-average risk projects have a WACC of 12%. Which of the following projects (A, B, and C) should the company accept? A:Project B is of below-average risk and has a return of 9.5%. B:Project C is of above-average risk and has a return of 11.5%. C:Project A is of average risk and has a return of 9%....

Projects A and? B, of equal? risk, are alternatives for expanding Rosa? Company's capacity. The? firm's...

Projects A and? B, of equal? risk, are alternatives for expanding Rosa? Company's capacity. The? firm's cost of capital is 11?%. The cash flows for each project are shown in the following? table: Project A Project B Initial investment ?(CF 0CF0?) ?$130,000 ?$100,000 Year ?(t?) Cash inflows ?(CF Subscript tCFt?) 1 ?$30,000 ?$30,000 2 ?$35,000 ?$30,000 3 ?$40,000 ?$30,000 4 ?$45,000 ?$30,000 5 ?$50,000 ?$30,000 a.??Calculate each? project's payback period. b.??Calculate the net present value? (NPV) for each project. c.??Calculate...

Projects A and B, of equal risk, are alternatives for expanding Rosa Company's capacity. The firm's...

Projects A and B, of equal risk, are alternatives for expanding Rosa Company's capacity. The firm's cost of capital is 13%. The cash flows for each project are shown in the following table: . a. Calculate each project's payback period. b. Calculate the net present value (NPV) for each project. c. Calculate the internal rate of return (IRR) for each project. d. Indicate which project you would recommend. Initial investment $160,000 $130,000 Year Cash inflows 1 $40,000 $40,000 2 $45,000 ...

A company with an average WACC of 10% adjusts for risk by adding 2% for high...

A company with an average WACC of 10% adjusts for risk by adding 2% for high risk projects and subjecting 2% for low risk projects. Which of the following projects should the company accept? Only one option can be an answer. A)An average risk project with an IRR of 10% B)Low risk project with an IRR of 7% C)High risk project with an IRR of 13% D)High risk project with IRR of 11%

Suppose Tapley Inc. uses a WACC of 8% for below-average riskprojects, 10% for average-risk projects,...

Suppose Tapley Inc. uses a WACC of 8% for below-average risk projects, 10% for average-risk projects, and 12% for above-average risk projects. Which of the following independent projects should Tapley accept, assuming that the company uses the NPV method when choosing projects?A). Project A, which has average risk and an IRR = 9%.B). Project B, which has below-average risk and an IRR = 8.5%.C). Project C, which has above-average risk and an IRR = 11%.D). Without information about the projects'...

A project has the following cash flows. This project is of average risk and the WACC...

A project has the following cash flows. This project is of average risk and the WACC is 0.1. Find the Net Present Value. Round your answer to two decimal places. Year 0 Year 1 Year 2 Year 3 Cash Flow -$91 $50 $40 $7

WACC and optimal capital budget Adamson Corporation is considering four average-risk projects with the following costs...

WACC and optimal capital budget Adamson Corporation is considering four average-risk projects with the following costs and rates of return: Project Cost Expected Rate of Return 1 $2,000 16.00% 2 3,000 15.00 3 5,000 13.75 4 2,000 12.50 The company estimates that it can issue debt at a rate of rd = 10%, and its tax rate is 35%. It can issue preferred stock that pays a constant dividend of $6 per year at $48 per share. Also, its common...

Home Ltd. has the option of investing in the following two projects of equal risk; they...

Home Ltd. has the option of investing in the following two projects of equal risk; they are mutually exclusive alternatives for expanding the firm’s capacity. The firm’s cost of capital is 12%. The cash flows for each project are given in the following table. PROJECT A PROJECT B Initial investment 545,000 300,000 Year Net cash inflows Net cash inflows 1 135,000 200,000 2 185,000 120,000 3 220,000 92,000 4 280,000 Home Ltd. has incurred a research and development expenditure of...

Home Ltd. has the option of investing in the following two projects of equal risk; they...

Mr. Jones has $10,000 to invest in three types of stocks: low-risk, medium-risk and high-risk. He...

Mr. Jones has $10,000 to invest in three types of stocks: low-risk, medium-risk and high-risk. He invests according to the following rules: the amount invested in low-risk stocks will be at most $2000 more than the amount invested in medium-risk stocks. At least $4000 will be invested in a combination of low- and medium-risk stocks. No more than $8,000 will be invested in a combination of medium- and high-risk stocks. The expected annual returns are 6% for low-risk stocks, 7%...

Subjects