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The Risk Adjusted WACC for New Business

The Reasons for Risk Adjusted WACC

Calculating a risk adjusted WACC

Example for Risk Adjusted WACC

Some Supplementary Key Points for AFM Exam

The Reasons for Risk Adjusted WACC

The WACC can only be used for project evaluation if:

(a)In the long term the company will maintain its existing capital structure (ie financial risk unchanged)

(b)The project has the same risk as the company (ie business risk is unchanged)

If the business risk of the new project differs from the entity's existing business risk:

•        A risk adjusted WACC can be calculated, by recalculating the cost of equity to reflect the business risk of the new project. This often involves the technique of degearing'and 'regearing'beta factors.

If the capital structure(financial risk) is expected to change when the new project is undertaken

•        The simplest way of incorporating a change in capital structure is to recalculate the WACC using the new capital structure weightings.

Calculating a risk adjusted WACC

1. Find the appropriate equity beta from a suitable quoted company.

2. Adjust the available equity beta to convert it to an asset beta-degear it.

3. Readjust the asset beta with new capital structure weightings to reflect the project(i.e. its own) gearing levels-regear the beta.

4. Calculate the cost of equity of the project based on CAPM(Ke).

5. Calculate the WACC of the project with the calculated Ke.