Question

Discuss briefly and evaluate the following statements for accuracy.

1. If management is willing to fund multiple value-added projects and it has no hard capital constraints, it is recommended that it accepts the projects with the highest average IRR.
2. If a company has no debt, its WACC (i.e., cost of capital) must be equal to its Cost of Equity.

Answer 1

1. If management is willing to fund multiple value-added projects and it has no hard capital constraints, it is recommended that it accepts the projects with the highest average IRR.

The above statement is inaccurate. The reason for its inaccuracy is that, if the company would accept the projects with highest average IRR then most of the projects would likely to be selected because of comparison between IRR and cost of capital. As per the financial theory, if cost of capital is below IRR then such project should be chosen otherwise rejected. Therefore, a benchmark IRR for the industry should be chosen so that every project could be evaluated for its financial viability.

Hence such statement is inaccurate.

2. If a company has no debt, its WACC (i.e., cost of capital) must be equal to its Cost of Equity.

The above statement is accurate. The reason for its accuray lies in its mathematical expression.

Following is formula for the computation of WACC:

WACC=[Cost of Debt*(1-Tax Rate)]* Debt/Equity + [Cost of Equity]* Debt/Equity

Now if in the above formula, value of debt will be zero then cost of debt will automatically be zero. This implies that such a company is financed through equity. Thus its WACC will be equal to cost of equity.

Hence above statement is accurate.