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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

Which statement about using WACC as the discount rate for a new project is most appropriate?

WACC is suitable as the project discount rate only when the project has similar business risk to the firm and does not change its capital structure. Otherwise a risk-adjusted rate reflecting the project's own risk should be used.

  1. AIt is valid for any project regardless of risk
  2. BIt is valid only if the project has similar business risk to the existing firm and leaves the capital structure unchangedCorrect
  3. CIt should always be replaced by the cost of debt
  4. DIt should use book values of equity rather than market values
  5. It should exclude the tax shield on debt

Explanation

WACC reflects the risk and financing mix of the existing firm. It is appropriate only when the project has similar business risk and does not alter the gearing materially. For projects with different risk, a project-specific rate is needed.

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