Exam Review Explanation for Cost of Capital for Risk

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Final Exam Review
Adjusting Cost of Capital for Risk

This is a potential question on the Final Exam. I wanted to go through each of the answers for this question because we did not cover this information in Seminar or in the lectures in the discussion thread. You will find this information in the text under section 10.9 Adjusting the Cost of Capital for Risk. Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a 12% WACC. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project. Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of projects X and Y. Which of the following statements is CORRECT? A.Safeco/Risco's WACC, as a result of the merger, would be 10%. B.If evaluated using the correct post-merger WACC, Project X would have a negative NPV. C.After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y. D.If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will become riskier over time. E.After the merger, Safeco/Risco should select Project Y but reject Project X.

Don’t let all the words in the question scare you. Write out each Company’s information separately so you know what you are dealing with.

SafecoRiskco
WACC = 10%WACC = 12%
Project X IRR = 10.5% Project Y IRR = 11.5%
Project X WACC = 10% (Similar to Safeco’s)Project Y WACC = 12% (similar to Riskco’s)

When the companies merge, the combined company’s WACC...
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