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?
a) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
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%.
d) Therefore, it should reject Project X but accept Project Y.

Answer 1

Answer:

All the statements are true:

• a) If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will probably become riskier over time.
• 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%.
• d) Therefore, it should reject Project X but accept Project Y.

Explanation:

Safeco's WACC 10%

Risco's WACC 12%

combined WACC after merger = (10% + 12%) / 2 = 11%

since the combined WACC is 11%, Safeco's project X will not be accepted (before it was accepted because it had a positive NPV), while Risco's project Y will be accepted (before it was not accepted because it had a negative NPV).