Hi everyone,
I’ve tried searching for this but I haven’t been able to find the answer. I vaguely remember seeing this in Level 1 but I’ve forgotten!
When WACC equals the cost of equity - what investment decisions does this lead to?
I.e will you be accepting risky projects? Not accepting risky projects?
Thank you.
Who cares, bro? ;-)))))))
I don’t think accept or refuse a risky project depend on WACC or cost of equity of the company because the discount rate of each project depend only on its risks.
lol have you started studying for L2 today?
Maybe I should’ve elaborated… if you use cost of equity instead of WACC - from a valuation perspective what does this lead too.
I understand a higher discount rate will undervalue a project and a lower discount rate will overvalue the project… but if they are equal? Are you accepting an average risk/valuation?
I said you shouldn’t use the WACC or cost of equity of company as discount rate. You should find the discount rate corresponding to the risks of the project.
if you use a higher discount rate than you should be, you’re going to reject a lot more projects and potentially profitable projects (discounted at the appropriate rate, which is lower than what you use)
if you use a lower discount rate than you should be, you’re going to accept a lot more projects and potentially risky one
Thank you. This makes sense.
What about when the rates are equal?
I was actually looking for the answer was well. My educated guess will be you take on too many average-risk projects.
equal rates = same denominator / discount rate used = same NPV = same accept/reject decisions
From a Modigliani and Miller perspective, if r(e)=r(w) that means you have zero debt. Since debt is tax-deductible and equity isn’t then you will have a sub-optimal capital structure. More debt is better because the tax shield lowers your wacc.
Static trade off theory says lever up to lower your wacc until PV(financial distress) gets too high.
Taking all technical information aside, if you were going to invest in a project that only made you back the money you invested exactly, would you take that project on?
The answer is no. So I do not see any reason why you would therefore accept any project where WACC = cost of equity. No one invests to break even. With NPV you are looking for excess returns. There is none in your example so I will say no
Take a look at this post
https://www.analystforum.com/forums/cfa-forums/cfa-level-ii-forum/91310262
And the situation when WACC = re (cost of equity) is least likely possible.
Why? Because WACC = rd * (1-tax) * wd + re * we. if WACC =r** e and if wd<> 0**, you will have rd * (1-tax) =re => rd is at least greater than re. And ifwd = 0, the assumption WACC = re is meanningless.
Is rd at least greater than re possible? No, because a debt is always less risky than an equity. Who will accept to become shareholder if he can invest as debtholder with a higher return and a guarantee of being paid first in case of bankcrupcy?
@rexthedog You’re confusing WACC and cost of equity with return. WACC/RCE is the cost of financing the project and the hurdle rate that the project needs to exceed, not the return on the capital invested. There is nothing wrong with accepting a project that has the same WACC as the cost of all equity financing as long as the project generates a return sufficient to provide a positive NPV. However, often projects carry more risk and should be discounted at a higher rate than the company’s WACC. So if you had used the WACC as a standard discount rate, it would lead you to accepting more higher risk projects.
If you are using a hurdle rate equal to company WACC to find the NPV of the project, there will be a risk that this hurdle rate is too low. Therefore, it make the NPV of the risky project higher, and you will end up accepting these projects.