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ACCA Strategic Professional · Strategic Business Leader · Financial analysis and decision-making techniques

Lumen Retail Group is considering a project in a new line of business that is much riskier than its existing stores. The finance director proposes appraising it using the group's current weighted average cost of capital (WACC), because the group's financing mix will not change. What is the main weakness of this proposal?

The weakness is that the group's existing WACC reflects the risk of its current stores. A riskier new business needs a higher, risk-adjusted discount rate, so using the current WACC understates the required return and may cause the company to accept projects that destroy shareholder value.

  1. AWACC ignores the tax shield on debt interest, so it overstates the cost of capital
  2. BThe group's existing WACC reflects the risk of existing operations, so using it for a riskier project would understate the required return and could lead to accepting value-destroying projectsCorrect
  3. CWACC can only be used when a company has no debt in its capital structure
  4. DThe WACC should be replaced with the cost of retained earnings alone, since it is the cheapest source of funds

Explanation

WACC is appropriate only when the project has the same business risk as the existing business and does not change the financial risk. A riskier project needs a higher, risk-adjusted discount rate, for example using a proxy company's asset beta. WACC does include the debt tax shield, and it is not restricted to debt-free firms.

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