The SML and the WACC

When we are evaluating investments with risks that are substantially different from those of the overall firm, the use of the WACC will potentially lead to poor decisions. Figure 15.1 illustrates why.

In Figure 15.1, we have plotted an SML corresponding to a risk-free rate of 7 percent and a market risk premium of 8 percent. To keep things simple, we consider an all-equity company with a beta of 1. As we have indicated, the WACC and the cost of equity are exactly equal to 15 percent for this company because there is no debt.

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

PART SIX Cost of Capital and Long-Term Financial Policy

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