Calculation of IRR for the project and WACC.
1. 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 12% WACC. 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?
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 would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
d.If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will become riskier over time.
e.After the merger, Safeco/Risco should select Project Y but reject Project X.
2. Blanchford Enterprises is considering a project that has the following cash flow data. What is the project's IRR? Note that a project's projected IRR can be less than the WACC (and even negative), in which case it will be rejected.
|
Year
|
0
|
1
|
2
|
3
|
|
Cash flows
|
-$1,000
|
$450
|
$450
|
$450
|
a.16.20%
b.16.65%
c.17.10%
d.17.55%
e.18.00%