A firm's WACC can be correctly used to discount the expected cash flows of a new project when that project will:

a. be financed solely with internal equity.

b. be financed based on the firm's current debt-equity ratio.

c. be financed solely with new debt and internal equity.

d. have the same level of risk as the firm's current operations.

e. be managed by the firm's current managers.

Question

Business

Gabriella Cantu

8 August, 02:29

A firm's WACC can be correctly used to discount the expected cash flows of a new project when that project will:

a. be financed solely with internal equity.

b. be financed based on the firm's current debt-equity ratio.

c. be financed solely with new debt and internal equity.

d. have the same level of risk as the firm's current operations.

e. be managed by the firm's current managers.

+2

Answers (1)

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Stephanie Ramos · Answer 1

b. have the same level of risk as the firm's current operations.

Explanation:

According to the M&M's model of capital structure, two entities operating in the same type of business with similar business risks (e. g proportion of variable costs to fixed costs, operating profits) have the same total value irrespective of their capital structures. This means that in order for WACC to be relevant for discounting purposes of a new project it's important that the new project and the firm's risks are same (at least the business risks).

Secondly, having same level of risk also means that the project will have a similar operating income generated by it's assets, hence when the return of two projects is similar the cost of finance/business will also be similar therefore the new project must share same level of risk in order for WACC to be used as a discount rate.