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Business Administration QUESTION #9603
Question 1
A firm's Weighted Average Cost of Capital (WACC) is 12%, and a proposed project has an Internal Rate of Return (IRR) of 9%. A manager argues the project should still be accepted because it generates positive cash flows. Which financial principle does the manager's argument violate, and what is the correct decision?
  • The manager violates the payback period principle — projects must recover their investment within the firm's standard payback window regardless of IRR
  • The manager violates the value creation principle — a project whose IRR is below the WACC destroys shareholder value because it earns less than the cost of the capital deployed in it; the project should be rejected✔️
  • The manager violates the diversification principle — a single project with sub-WACC returns should be bundled with higher-return projects to achieve a blended acceptable return
  • The manager is correct — positive cash flows always create value regardless of the cost of capital used to generate them
Correct Answer Explanation
WACC represents the minimum return required to satisfy all capital providers (debt and equity). A project with IRR below WACC earns less than what it costs to finance — it destroys economic value even while generating positive accounting cash flows. Accepting such a project dilutes shareholder returns and reduces firm value. This is the core principle of economic value added (EVA) and Net Present Value (NPV) decision rules: NPV would be negative, confirming rejection.