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Further aspects of investment appraisal

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A risk adjusted WACC is needed to calculate a project NPV  if the if the financial risk of the company is expected to stay constant but the business risk is expected to change significantly as a result of undertaking a project. A discussion of different approaches to investment appraisal can be found here.

Calculation

Basic principle

If the business risk of the new project is different from the business risk of a company's existing operations, the company's shareholders will expect a different return to compensate them for this new level of risk.

Hence, the appropriate WACC which should be used to discount the new project's cash flows is not the company's existing WACC, but a "risk adjusted" WACC that incorporates this new required return to the shareholders (cost of equity).

Calculating a risk-adjusted WACC

(1) Find the appropriate equity beta to match the business activities of the project from a suitable similar quoted company.

(2) Adjust the available equity beta to convert it to an asset beta - degear it.

(3) Readjust the asset beta to reflect the project (i.e. its own) gearing levels - regear the beta.

(4) Use beta to find Ke using CAPM.

(5) Use this Ke to find the WACC.

(6) Evaluate the project by calculating a NPV.

Using the risk-adjusted WACC

The risk-adjusted WACC calculated above reflects the business risk of the project and the current capital structure of the business, so it is wholly appropriate as a discount rate for the new project.

Two other issues also need to be considered:

• The method used to gear and degear betas is based on the assumptions that debt is perpetual and risk free. This overvalues the tax shield where debt is finite.
• Issue costs on equity are ignored.
 Created at 9/14/2012 2:17 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London Last modified at 11/13/2012 2:41 PM  by System Account  (GMT) Greenwich Mean Time : Dublin, Edinburgh, Lisbon, London

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ACCAPEDIA - Risk adjusted WACC