Question

In order to use the WACC to evaluate a future project's flows, which of the following must hold?

A) The project will be financed with the same proportion of debt and equity as the firm.
B) The systematic risk of the project is the same as the overall systematic risk of the firm.
C) The project must be viable.
D) a and b above.

Answer 1

To use WACC to evaluate a project's cash flows, the project should have the same debt-to-equity ratio as the firm and the same systematic risk. Condition C is important but not for WACC's appropriateness.

Step-by-step explanation:

To properly use the Weighted Average Cost of Capital (WACC) for evaluating a future project's cash flows, certain conditions must be met. Notably, option D ('a' and 'b' above) is the correct choice:

• The project should be financed with the same proportion of debt and equity as the firm (Condition A).
• The systematic risk of the project should match the firm's overall systematic risk (Condition B).

Both of these conditions ensure that the WACC, which incorporates the cost of capital from both debt and equity financing, accurately reflects the project's potential returns relative to its financial risk profile.

Condition C, which states that the project must be viable, is indeed important for a project, but it is not specifically related to the appropriateness of using WACC for evaluation purposes.