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ACCA Strategic Professional · Advanced Financial Management · Discounted cash flow techniques

A firm's existing WACC is 9%. It evaluates a project with a higher business risk than the firm, but incorrectly uses 9%. What is the most likely consequence?

The firm will tend to accept high-risk projects that have negative NPV at the correct risk-adjusted rate. Using a rate that is too low overstates the present value of the project's cash flows, so overall the firm would over-accept risky projects.

  1. AIt will tend to reject good low-risk projects and accept all high-risk projects only if their NPV is negative
  2. BIt will tend to accept projects whose true risk-adjusted NPV is negativeCorrect
  3. CIt will tend to reject projects whose true risk-adjusted NPV is positive
  4. DIt will have no effect because NPV is independent of the discount rate

Explanation

A discount rate that is too low for a riskier project overstates the present value of its cash flows. Hence NPV is overstated and the firm may accept projects that destroy value when correctly discounted. The reverse applies to lower-risk projects, which would be wrongly rejected.

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