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 12% and Risco a 14% WACC. Safeco is considering Project X, which has an IRR of 12.5% and is of the same risk as a typical Safeco project. Risco is considering Project Y, which has an IRR of 13.5% 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?
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After the merger, Safeco/Risco would have a corporate WACC of 13%. Therefore, it should reject Project X but accept Project Y.
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If evaluated using the correct post-merger WACC, Project X would have a negative NPV.
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If the firm evaluates these projects and all other projects at the new overall corporate WACC, it will become riskier over time.
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Safeco/Risco’s WACC, as a result of the merger, would be 12%.
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