Safeco Company and Risco Inc are identical in size and capital structure. However, the riskiness of their assets and cash flows are somewhat different, resulting in Safeco having a WACC of 10% and Risco a WACC of 12%. Safeco is considering Project X, which has an IRR of 10.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 11.5% and is of the same risk as a typical Risco project.
Now assume that the two companies merge and form a new company, Safeco/Risco Inc. Moreover, the new company's market risk is an average of the pre-merger companies' market risks, and the merger has no impact on either the cash flows or the risks of Projects X and Y. Which of the following statements is CORRECT?
Answer
a. Safeco/Risco's WACC, as a result of the merger, would be 10%.
b. If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
c. After the merger, Safeco/Risco should select Project Y but reject Project X. If the firm does this, its corporate WACC will fall to 10.5%.
d. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
e. After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.