Question

Assume a firm uses the one hurdle rate to evaluate all potential projects. Consider two possible cases: (1) The cost of capital for a project under consideration is actually below the firm’s hurdle rate, and (2) the cost of capital for a project under consideration is actually above the firm’s hurdle rate.

• In each case, discuss what happens to the valuation process, and in which direction can capital budgeting be erroneous.

Answer 1

1: The cost of capital for the project is lesser but a higher rate is used. The project is hence valued at a lower price. This will result in lower value for a project which may be more profitable and hence incorrect rejection on that basis.

2: The cost of capital for a project under consideration is actually above the firm’s hurdle rate. The project is hence valued at a higher value than it actually is. This will result in incorrect acceptance of a project.