Page 133 - AFM Integrated Workbook STUDENT S18-J19

Risk adjusted WACC and adjusted present value

Introduction

1.1 Risk and investment appraisal

When appraising a new investment project, the company’s existing WACC
should only be used as a discount rate for the cash flows if BOTH the
business risk and the capital structure (financial risk) are likely to stay
constant.

1.2 What if the business risk of the new project differs from the
company's existing business risk?

A risk adjusted WACC can be calculated, by recalculating the cost of
equity to reflect the business risk of the new project.

This often involves the technique of 'degearing' and 'regearing' beta
factors.

1.3 What if the capital structure (financial risk) is expected to
change when the new project is undertaken?

The simplest way of incorporating a change in capital structure is to
recalculate the WACC using the new capital structure weightings.
However, this is only appropriate when the change in capital structure is
not significant.

If the capital structure is expected to change significantly, the Adjusted
Present Value method of project appraisal should be used.

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