1.in MM II (No taxes), why would WACC be linear (flat) just because required return on equity is going up? I mean for example, when 100% debt is used, WACC should have no equity weighting and therefore should not be affected by the increasing required rate on equity. Am I missing something here? 2. Given r, required rate of return and q, the probability of the project failing in a certain year, the adjusted rate has the formula:
r* = (1+r)/(1-q) - 1 But I’m wondering why this is used instead of simply r/(1-q).
For example, if r = 60% and q = 80% first formulas gives [(1.6)/0.2] - 1 = 700%, but the other formula simply does 0.6/0.2 = 300% which makes intuitive sense to me (20% success, therefore we take r and times 5).
If you have (1-q) probability of not failing, it requires a higher rate r^ to compensate for the probability of failing. You want to have a return of r, but there is some probability of failing. You need to require more, that is r*, to average out on (1 + r).
This is not how a professional would explain it, but it helps ME to remember the formula… and that r* must be larger than r, since the other factor is < 1.