Ross et al.: Fundamentals
of Corporate Finance, Sixth
Edition, Alternate EditionVI. Cost of Capital and
Long−Term Financial
Policy(^538) 15. Cost of Capital © The McGraw−Hill
Companies, 2002
Suppose our firm uses its WACC to evaluate all investments. This means that any in-
vestment with a return of greater than 15 percent will be accepted and any investment
with a return of less than 15 percent will be rejected. We know from our study of risk and
return, however, that a desirable investment is one that plots above the SML. As Figure
15.1 illustrates, using the WACC for all types of projects can result in the firm’s incor-
rectly accepting relatively risky projects and incorrectly rejecting relatively safe ones.
For example, consider Point A. This project has a beta of (^) A.60, as compared to
the firm’s beta of 1.0. It has an expected return of 14 percent. Is this a desirable invest-
ment? The answer is yes, because its required return is only:
Required return Rf
A(RMRf)
7% .60 8%
11.8%
However, if we use the WACC as a cutoff, then this project will be rejected because its
return is less than 15 percent. This example illustrates that a firm that uses its WACC
as a cutoff will tend to reject profitable projects with risks less than those of the over-
all firm.
At the other extreme, consider Point B. This project has a beta of (^) B1.2. It offers a
16 percent return, which exceeds the firm’s cost of capital. This is not a good investment,
however, because, given its level of systematic risk, its return is inadequate. Nonetheless,
510 PART SIX Cost of Capital and Long-Term Financial Policy
FIGURE 15.1
Expected
return (%)16
15
14BetaWACC = 15%Rf = 7Incorrect
rejectionIncorrect
acceptance(^) A = .60 (^) firm = 1.0 (^) B = 1.2
SML
= 8%
B
A
If a firm uses its WACC to make accept-reject decisions for all types of projects, it will have
a tendency towards incorrectly accepting risky projects and incorrectly rejecting less risky
projects.
The Security Market Line (SML) and the Weighted Average Cost of Capital (WACC)