Using the WACC to evaluate all projects may lead managers into accepti

Using the WACC to evaluate all projects may lead managers into accepting high-risk projects that do not compensate adequately for risk and into rejecting low-risk projects

that compensate fully for the level of risk but may not have particularly high rates of return. Describe the situations when using a WACC is not appropriate and how these incorrect decisions may be made.
What will be an ideal response?

ANSWER

Answer: If managers could estimate the beta for every project and thereby a required rate of return for every project, then the capital budgeting process would always lead to good decision-making. Higher-risk projects would have a higher required return and lower-risk projects would have a lower required return. But assigning a “one-size-fits-all” WACC to every project could lead a manager to accept a project that has an IRR that is greater than the WACC (i.e., a positive NPV) but that is lower than its true required rate of return. Conversely, a manager might reject a low-risk project with an acceptable return for that level of risk because the IRR is less than the WACC (implying a negative NPV). In that case, the WACC would be a value that is too high to correctly evaluate the lower-risk project.