The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects. The firm's overall WACC is 12%. The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects. The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources. If the CEO's position is accepted, what is likely to happen over time?
A) the company will take on too many low-risk projects and reject too many high-risk projects.
B) things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
C) the company's overall wacc should decrease over time because its stock price should be increasing.
D) the ceo's recommendation would maximize the firm's intrinsic value.
E) the company will take on too many high-risk projects and reject too many low-risk projects.

Question

Quizplus · Accepted Answer

Low-risk projects will tend to have low expected returns and vice versa for high-risk projects due to competition in the economy. By not adjusting the cost of capital for project risk, the firm will tend to reject low-risk projects even though they earn higher returns than their risk-adjusted costs of capital, and vice versa for high-risk projects. In addition, as the firm takes on more high-risk projects, its correct WACC will increase over time. Therefore, statement e is correct.

The Anderson Company Has Equal Amounts of Low-Risk, Average-Risk, and High-Risk