Question

What are the arguments for and the arguments against discounting every project by its own cost of capital? Q 12.27

Answer 1

Arguments for discounting every project by its own cost of capital:

1. The project's risk might be different from that of the company

2. A venture into a completely new business would require that to be discounted at its own cost of capital instead of the firm's WACC

3. Specific kinds of projects (Like foreign projects) might be impacted by intangible factors like poilitical scenario and climatic scenario. These would not impact the rest of the firm and hence the project would need to be discounted at its own cost of capital

Argument against discounting every project at its own cost of capital:

1. The rate at which the company would be able to raise money to finance the project would depend upon the return the investors are expecting from the company (i.e the company's WACC). Hence, the projects must be discounted at the WACC.