Your company’s WACC is 11%. It is planning to undertake a project with an intern

Question

Your company’s WACC is 11%. It is planning to undertake a project with an internal rate of return of 14%, but you believe this project is not a wise investment. What logical arguments would you use to convince your boss to forego the project despite its high IRR. Is it possible that making investments with returns higher than the firm’s cost of capital will destroy value? If so, how?

What is the market line? Why should a firm reject a projects lying below the market line and accept those lying above the line.

Explanation / Answer

1)When projects that are riskier have to be assessed at higher cost of equity than projects that are safer.

so we can say that different project may have different cost of capital based on risk involved.If new project is riskier ,then its expected cost of capital will be higher than other projects thus we can make argument that since such project involve high cost of capital than others it shall be rejected even have higher IRR than normal cost of capital.

2)If The IRR(14%) of project is higher than Firms cost of capital(11%) it may be possible that it destroys its value if the expected cost of capital (15%) on new project is higher than firm cost of capital due to risk involved .In such a case even if the IRR is more than firm cost of capital , it will destroy firm value as xpected cost of capital is higher than IRR of project.

3)Market line is a graphical representation of securities return and risk .

4)Securities above or on market line should be accepted as they represent optimum combination of securities.generating Higher returns with minimum risk.

Such securities represents dominance over other securities (falling below line)

thus securities falling below market line should be rejected as they carry high risk with lower returns.

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