The Nunnally Company has equal amounts of low-risk,average-risk, and high-risk p

Question

The Nunnally Company has equal amounts of low-risk,average-risk, and high-risk projects. Nunnally estimates thatits overall WACC is 12%. The CFO believes that this is thecorrect WACC for the company’s average-risk projects, butthat a lower rate should be used for lower risk projects and ahigher rate for higher risk projects. However, the CEO arguesthat, even though the company’s projects have differentrisks, the WACC used to evaluate each project should be the samebecause the company obtains capital for all projects from the samesources. If the CEO’s opinion is followed, what is likely tohappen over time?

The company will take on too many low-riskprojects and reject too many high-risk projects.

The company will take on too many high-riskprojects and reject too many low-risk projects.

Things will generally even out over time, and,therefore, the firm’s risk should remain constant overtime.

The company’s overall WACC shoulddecrease over time because its stock price should beincreasing.

The CEO’s recommendation would maximizethe firm’s intrinsic value.

Explanation / Answer

B, the company will take on too many high-risk projects and rejectlow-risk projects. The company is looking for projects with higher returns than theirWACC, or weighted average cost of capital. Higher riskprojects will have higher returns and will therefore be morefavorable than lower-risk projects. By not factoring in theindividual project risks, the CEO is doing the company adisservice. The company should demand higher returns forhigh-risk projects.

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