Answer:
b. Below-average risk
Explanation:
In order to understand why the company may want to accept project a, we need to understand what WACC is, which factors effect WACC and why investors choose to accept and reject certain projects based on WACC?
WACC stands for weighted average cost of capital which is made up of two components, Debt and Equity (the main long term sources of finance). WACC is the average expected return to equity and debt holders. Debt and Equity providers require a certain level of return on their money lent.
Debt finance is normally perceived as a cheaper source of finance as compared to equity because of two major factors, First, the cost of debt (i.e interest paid) is a tax deductible exp which means before taxing profits the amount of interest paid to debt providers is deducted resulting in reduced amount of taxable profit and hence a lower tax liability whereas cost of equity (i.e dividends) is not tax deductible. Second, debt providers are much safer than equity providers because they require security (by creating a charge over assets) over the debt issued, therefore lower risk leads to lower return.
From above we can conclude that the amount of debt and equity finance raised by a company can directly effect WACC.
Many entities use WACC as a discount factor for computing value of business. Value of Business = Future cash flows ÷ discount factor. This means a company with a higher WACC will normally have a lower business value (because the greater the discount factor, the lower value of company).
Therefore, companies keeping in mind the objective of value creation and wealth maximization try to minimize their WACC in order to maximize value of business. With this point of view Under inc. should accept project B(below-average risk)...
