Safeco Company and Risco Inc

question 35

Multiple Choice

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 12% WACC.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 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%. Therefore, it should reject Project X but accept Project Y.
• D)Safeco/Risco's WACC, as a result of the merger, would be 10%.

---

Definitions:

Cost of Capital

The rate of return that a company must earn on its investments to maintain its market value and satisfy its investors and creditors.

Foreign Project

A business venture or investment located outside the investor's domestic country, often subject to additional risks such as currency fluctuations and political instability.

Domestic Project

A project undertaken within a country's borders, focusing on local development or business activities.

Interest Rate Parity

A theory suggesting that the difference in interest rates between two countries is equal to the differential between the forward exchange rate and the spot exchange rate.