The question tells you to choose which options are required/must before a firm can use WACC for capital budgeting decisions?
A. Funded solely by internal sources of financing.
B. The firm should not materially change its financing policies as a result of the investments it undertakes.
C. The risk of the project is the same as existing operations.
I would say B
I am pretty sure that it is C.
The firm can use WACC when the risk of the project it is analyzing is the same of the existing operations. If the firm uses WACC to discount a project that it is deemed to be more risker than existing operations than the firm will overestimate the NPV, since a risk premium should be included in WACC to more significantly discount the cash flows. Just my two cents.
I’m inclined to choose c as a result of The risk of the project is the same as existing operations.
I would say C because the WACC applies to the firm as a whole so when choosing projects, the project must also refelct the average risk of the firm’s operations.
C. If the risk were diffr, you’d go for MCC. is the understanding correct S2000magician???
banker99 hit it head on
It seems like the OP says choose “which options,” meaning there can be more than one. And I think it’s B&C.
C, like folks here suggest, is correct. If the project is riskier, then the WACC must be higher. Vice versa if it’s a less risky project.
B is also correct. If you change your capital structure due to the investment, your WACC will not be the same for the new project as it’s using a marginally different mix of debt and equity. You can’t just use the company’s new WACC either, because theoretically, the old WACC funded the old operations, while the new WACC reflects the marginal change due to the new investment. You need to use the financing cost for the new investment, whatever mix of debt and equity that may be.
@geo: In case you change your capital structure in a way that your new mix of debt and equity remains the same, then B wouldn’t be a likely choice. So, B isn’t true for all the cases.
If your new debt and equity mix is the same, then you haven’t changed your capital structure.
Thanks @ Geo. How do you relate “B. The firm should not materially change its financing policies as a result of the investments it undertakes” to your answer?
Financing policies would be debt/equity mix. Could be different types of debt (bonds vs. banks, short vs. long, etc) or hybrids or whatever, but you’re changing your financing arragements so you’re changing your WACC.
Is it necessary that fin policies= chnage in cap structure? I mean does it cover nothing apart from capital structure? it looks like a broad term.
The answer should be C .The firm can apply WAAC when its analyzing the project with same risk as existing operations .
The answer should be C .The firm can apply WAAC when its analyzing the project with same risk as existing operations .
I might be inclined to agree if it said financial policies, perhaps that could refer to accounting stuff too. But it specifically said FINANCING policies. Devil in the details. If you change how you finance the business, which is what you’d be doing if you were making changes to your FINANCING policies, then your WACC changes.
What changes in financing policies would you have in mind that would not impact the WACC?
Note that the question says MATERIALLY change your FINANCING policies too.
I’m sticking with B&C being correct.