The Anderson Company Has Equal Amounts of Low-Risk, Average-Risk, and High-Risk

question 63

Multiple Choice

The Anderson Company has equal amounts of low-risk, average-risk, and high-risk projects.The firm's overall WACC is 12%.The CFO believes that this is the correct WACC for the company's average-risk projects, but that a lower rate should be used for lower-risk projects and a higher rate for higher-risk projects.The CEO disagrees, on the grounds that even though projects have different risks, the WACC used to evaluate each project should be the same because the company obtains capital for all projects from the same sources.If the CEO's position is accepted, what is likely to happen over time?

• A) The company will take on too many low-risk projects and reject too many high-risk projects.
• B) Things will generally even out over time, and, therefore, the firm's risk should remain constant over time.
• C) The company's overall WACC should decrease over time because its stock price should be increasing.
• D) The CEO's recommendation would maximize the firm's intrinsic value.
• E) The company will take on too many high-risk projects and reject too many low-risk projects.

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Definitions:

Disposable Income

The sum of funds households can spend and save after deducting income taxes.

APS

Average Propensity to Save, which measures the proportion of income that is saved rather than spent.

Capacity Utilization Rate

The percentage of a firm's total potential production capacity that is actually being utilized in the production of goods or services.

Manufacturing Firms

Companies engaged in the industrial process of converting raw materials into finished products through human labor and machinery.