'RoboMinds', an AI robotics firm, is considering diversifying into autonomous agricultural vehicles. This new venture has a significantly different risk profile from its current operations.

Why is it inappropriate for RoboMinds to use its current Weighted Average Cost of Capital (WACC) to appraise this new project?

Answer options:

The current WACC reflects the business risk of existing AI robotics operations, not the agricultural vehicle sector.

The new project will require entirely new debt financing, which invalidates the WACC formula.

Agricultural projects are heavily subsidized, meaning the cost of capital is effectively zero.

WACC can only be used for projects with a lifespan of less than 5 years.

How to approach this question

Identify the conditions required to use WACC for project appraisal (same business risk, same financial risk).

Full Answer

A.The current WACC reflects the business risk of existing AI robotics operations, not the agricultural vehicle sector.✓ Correct

A company's existing WACC is only suitable for appraising a new investment if the new investment has the same business risk as the company's existing operations, and if the company's financial risk (gearing) remains unchanged. Since RoboMinds is diversifying into a new sector, the business risk is different, so a project-specific discount rate (using CAPM) must be calculated.

Common mistakes

Assuming WACC is a universal hurdle rate for all company projects regardless of risk.

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