1310 WACC Describe the alternatives to using a firms WACC as a discount rate

1310 wacc describe the alternatives to using a firms

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of the cost of financing a new project given the firm’s current mix of debt and equity. 13.10 WACC: Describe the alternatives to using a firm’s WACC as a discount rate when evaluating a project. LO 4 Solution: There are two major reasons why WACC may not be used to discount new projects: 1. It is not appropriate to use a firm’s WACC to discount a project’s free cash flows if the systematic risk of the project is very different from the systematic risk of the firm. To account for this potential problem, some firms estimate discount rates that directly reflect the risk involved in the project’s cash flows. For example, a risky project might be assigned a discount rate that is significantly higher then the firm’s WACC. 2. It is not appropriate to use a firm’s WACC when a project that has the same systematic risk as the firm is not being financed using the same mix of debt and equity as the firm— for example, if a project will be financed entirely with equity. The project’s cash flows should be discounted using the cost of equity rather than the firm’s WACC. These two rates will be the same only if the firm has no debt.
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