Safeco Company and Risco Inc are identical in size and capital structure. Howeve

Question

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 If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
After the merger, Safeco/Risco would have a corporate WACC of 11%. Therefore, it should reject Project X but accept Project Y.
Safeco/Risco

Explanation / Answer

17. If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time. 18. Surveys indicate that the CAPM is the most widely used method for estimating the cost of equity. However, other methods are also used because CAPM estimates may be subject to error, and people like to use different methods as checks on one another. If all of the methods produce similar results, this increases the decision maker's confidence in the estimated cost of equity. 19. If M and W merge, then the merged firm MW should have a WACC that is a simple average of M's and W's WACCs. 20. A firm’s cost of retained earnings is the rate of return stockholders require on a firm’s common stock.

Related Questions

Navigate

• Browse (All)
• Browse S
• Subjects

---

---

Integrity-first tutoring: explanations and feedback only — we do not complete graded work. Learn more.