Question

What are the arguments for and the arguments against discounting every project by its own cost of capital? Q12.27

Answer 1

Argument for discounting project by its own cost of capital:

1. THe risk of the project might be different than the risk of the company and hence must be discounted at its own rate

2. Specific projects like foreign projects might be impacted by intangible factors like political and climatic factors which don't impact the firm's WACC

3. A company venturing into a new kind of business would require the project to be discounted at its own cost of capital instead of the company's WACC

Argument against discounting project by its own cost of capital:

1. The rate at which the company raises money would depend on the total risk of the company and hence the return on the project must be compared against that rate instead of the cost of capital of the project.