WACC when set constant

CFA Level I Corporate Finance
#1

I really dont understand the answer to this question about hurdle rates etc. Could someone pleae clarify what they are talking about? Why would one reject profitable investments and accept unprofitable?

Thanks

Assume a firm uses a constant WACC to select investment projects rather than adjusting the projects for risk. If so, the firm will tend to:

A) accept profitable, low-risk projects and accept unprofitable, high-risk projects. B) reject profitable, low-risk projects and accept unprofitable, high-risk projects. C) accept profitable, low-risk projects and reject unprofitable, high-risk projects.

Your answer: C was incorrect. The correct answer was B) reject profitable, low-risk projects and accept unprofitable, high-risk projects.

The firm will reject profitable, low-risk projects because it will use a hurdle rate that is too high. The firm should lower the required rate of return for lower risk projects. The firm will accept unprofitable, high-risk projects because the hurdle rate of return used will be too low relative to the risk of the project. The firm should increase the required rate of return for high-risk projects.

#2

I assume they meant "projects that would have been accepted (or rejected) had the correct hurdle rate been used.

If the firm uses a constant hurdle rate, I would assume they use a rate that captures the risk of the “average risk” project of the firm. In the typical estimation of WACC, it’s equivalent to assuming that you are buying all the RHS (i.e. debt and equity) claims of the firm. If ou did that, you would receive all the cash flows from the firm’s assets. So, the riskiness of your portfolio of claims would be equal to the riskiness of the firm’s assets. And therefore, so should the required return on your portfolio of claims.

But, if the project was riskier than the average one, you should use a higher hurdle rate. So, by using the average, your hurdle is too low, and you’ll end up accepting projects that would be rejected IF YOU USED A CORRECT (i.e. risk-adjusted) DISCOUNT RATE. And of course, the revernse holds for below-average risk projects.