The Internal Rate of Return WACC - Essay Example

On the other hand, understating the WACC will result in an overstatement of future cash flows and net present value, causing a negative net present value project to be accepted. If the project is a financing project, meaning that the cash flow at time 0 is positive and the cash flows in future periods are negative, overstating the WACC will result in an understatement of future cash flows and overstatement of net present value, causing a negative net present value project to be accepted. On the other hand, understating the WACC will result in an overstatement of future cash flows and understatement of net present value, causing a positive net present value project to be rejected.

In the discounted payback period approach, WACC is used as the discount rate for deriving the present value of future cash flows if the investment is financed by both debt and equity. The investment is accepted if the payback period of the investment is less than the cutoff time. Overstating the WACC will result in an understatement of future cash flows and overstatement of the payback period, causing a project that paybacks within the target payback period to be rejected. On the other hand, understating the WACC will result in an overstatement of future cash flows and understatement of the payback period, causing a project that pays back after the target payback period to be accepted.

In the internal rate of return approach, WACC is used as the hurdle rate for deciding whether to accept the project. If the project is an investment project, the project is accepted if the internal rate of return exceeds WACC. If the project is a financing project, the project is accepted if the internal rate of return is smaller than WACC. If the project is an investment project, overstating the WACC will result in the internal rate of return smaller than the WACC and an acceptable project to be rejected. On the other hand, understating the WACC will result in the internal rate of return greater than the WACC and an unacceptable project to be accepted. If the project is a financing project, overstating the WACC will result in the internal rate of return smaller than the WACC and an unacceptable project to be accepted. On the other hand, understating the WACC will result in the internal rate of return greater than the WACC and an acceptable project to be rejected.

In the profitability index approach, WACC is used as the discount rate for deriving the present value of future cash flows if the investment is financed by both debt and equity. The investment is accepted if the ratio of the present value of the future cash flows divided by the amount of investment is greater than 1. Overstating profitability index, causing an acceptable investment to be rejected. On the other hand, understating the WACC will result in an overstatement of future cash flows and profitability index, causing an unacceptable investment to be accepted. In capital structure decisions, the optimal capital structure will be the one that results in the lowest WACC. Overstating or understating the WACC will result in a sub-optimal capital structure.