9. The treasurer of a large firm is considering investing $50 million in 10-year Treasury notes that yield 8.5%. The firm’s WACC is 15%. Is this a negative-NPV project? Explain.
In a perfect market scenario, this would be a negative-net present value (NPV) project. This is due to the greater required return/weighted average cost of capital (WACC) being greater than the expected return (15% vs. 8.5%). However, the estimated WACC is an effective estimate only for projects that are similar in operating and financing leverage to past and current projects (Emery, Finnerty, & Stowe, 2007). If the project differs from past and current ones, the risk of the present project must be taken into account to decide if the NPV is positive or negative. If this approach is not adopted, it is possible that the risk factor associated with the firm will increase over time, as will the debtholders required return on investment (Emery, Finnerty, & Stowe, 2007). Instead, risk-adjusted costs of capital should be used to analyze potential projects. By adjusting for risk, it is possible that these Treasury notes offer an appropriate return for the risk that they present. The firm should compare the cost of capital of the Treasury notes to the project’s cost of capital (Emery, Finnerty, & Stowe, 2007). Treasury notes are fairly low-risk investments. Investors are more likely to take on this low risk, relative to higher-risk investments. Further, Treasury notes demand a reduced required return, because they more closely approximate investments with riskless return, compared to other investment types (Emery, Finnerty, & Stowe, 2007). Therefore, opportunity costs (in the form of required returns) also are reduced with Treasury bonds, compared to some other market securities. This would allow the firm greater financial ability to take on more positive-NPV projects.
Emery, D.R., Finnerty, J.D., & Stowe, J.D. (2007). Corporate financial...
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