The McCue Company has equal amounts of low-risk,average-risk,and high-risk projects.McCue estimates that its 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?

Question

Quizplus · Accepted Answer

Using a single WACC for projects of different risk levels will lead to overvaluing high-risk projects (because their risk is not adequately accounted for by a higher discount rate) and undervaluing low-risk projects (because their lower risk is not rewarded with a lower discount rate). This will likely result in the company accepting too many high-risk projects and rejecting too many low-risk projects.

The McCue Company Has Equal Amounts of Low-Risk,average-Risk,and High-Risk Projects