Page 129 - AFM Integrated Workbook STUDENT S18-J19

The weighted average cost of capital (WACC)

Use of the WACC in investment

appraisal

4.1 Risk considerations

When evaluating a project, it is important to use a cost of capital which
is appropriate to the risk of the new project. The existing WACC will
therefore be appropriate as a discount rate if both:

 the new project has the same level of business risk as the existing
operations. If business risk changes, required returns of
shareholders will change (to compensate them for the new level of
risk), and hence WACC will change.

 undertaking the new project will not alter the firm's gearing
(financial risk). The values of equity and debt are key components
in the calculation of WACC, so if the values change, clearly the
existing WACC will no longer be applicable.

If one or both of these factors do not apply when undertaking a new
project, the existing WACC cannot be used as a discount rate. The next
chapter explores the alternative methods available in these situations.

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