Sml

Beta

If a firm uses its WACC to make accept-reject decisions for all types of projects, it will have a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky projects.

Suppose our firm uses its WACC to evaluate all investments. This means that any investment with a return of greater than 15 percent will be accepted and any investment with a return of less than 15 percent will be rejected. We know from our study of risk and return, however, that a desirable investment is one that plots above the SML. As Figure 15.1 illustrates, using the WACC for all types of projects can result in the firm's incorrectly accepting relatively risky projects and incorrectly rejecting relatively safe ones.

For example, consider Point A. This project has a beta of (3A = .60, as compared to the firm's beta of 1.0. It has an expected return of 14 percent. Is this a desirable investment? The answer is yes, because its required return is only:

Required return = Rf + pA X (RM - Rf) = 7% + .60 X 8% = 11.8%

However, if we use the WACC as a cutoff, then this project will be rejected because its return is less than 15 percent. This example illustrates that a firm that uses its WACC as a cutoff will tend to reject profitable projects with risks less than those of the overall firm.

At the other extreme, consider Point B. This project has a beta of = 1.2. It offers a 16 percent return, which exceeds the firm's cost of capital. This is not a good investment, however, because, given its level of systematic risk, its return is inadequate. Nonetheless,

Ross et al.: Fundamentals of Corporate Finance, Sixth Edition, Alternate Edition

VI. Cost of Capital and Long-Term Financial Policy

15. Cost of Capital

© The McGraw-Hill Companies, 2002

CHAPTER 15 Cost of Capital if we use the WACC to evaluate it, it will appear to be attractive. So the second error that will arise if we use the WACC as a cutoff is that we will tend to make unprofitable investments with risks greater than those of the overall firm. As a consequence, through time, a firm that uses its WACC to evaluate all projects will have a tendency to both accept unprofitable investments and become increasingly risky.

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