Introduction to Corporate Finance

PART 3: CAPITAL BUDGETING

11-1 CHOOSING THE RIGHT DISCOUNT

R ATE

When we consider what discount rate to use for our present value calculations, we can see that we have

several choices. The choices depend on the source of capital being used for the investment as well as the

nature of the investment risks that the organisation faces. In this section we examine some alternatives,

building up from the return on equity to the weighted average cost of capital (WACC), and making

comparisons with calculations arising from the CAPM, which was introduced in Chapter 7.

11-1a COST OF EQUITY

What discount rate should managers use to calculate a project’s NPV? This is a difficult question, and

is at times the source of heated discussions when companies evaluate capital investment proposals.

A project’s discount rate must be high enough to compensate investors for the project’s risk.

Thus, conceptually, the discount rate should reflect the return on an alternative (or ‘opportunity’)

project of equal risk. One implication of this statement is that if a company undertakes many different

investment projects of various degrees of risk, then managers err if they apply a single, company-wide

discount rate to value each investment. In principle, the appropriate discount rate to use in NPV

calculations should vary from one investment to another if the risks vary across investments. Interestingly,

survey data suggests that companies do not always follow this principle: CFOs appear to be fairly evenly

split regarding the use of company-wide versus project-specific discount rates in NPV calculations.

To simplify things a little, we initially consider a company that finances its operations using only

equity and invests in only one industry. Because the company has no debt, its investments must provide

returns sufficient to satisfy just one type of investor: ordinary shareholders. Because the company invests

in only one industry, we will assume that all its investments are equally risky. Therefore, when calculating

This chapter concludes our coverage of capital

budgeting. Chapter 9 supported the virtues of NPV

analysis, and Chapter 10 showed how to generate

the cash flow estimates required to calculate a

project’s NPV. This chapter focuses on the risk

dimension of project analysis. To calculate NPV,

an analyst must evaluate the risk of a project and

decide what discount rate adequately rewards

investors for bearing that risk. Often, the best place

to discover clues for use in estimating the discount

rate is the market for the company’s securities.

The chapter begins with a discussion of how

managers can look to the market to calculate

a discount rate that properly reflects the risk of

a company’s investment projects. Even when

managers are confident that they have estimated

project cash flows carefully and have chosen

a proper discount rate, they should perform

additional analysis to understand the causes

and effects of a project’s risk. Their tools include

breakeven analysis, sensitivity analysis, scenario

analysis, simulation and decision trees – all

covered in this chapter. We conclude with sections

on real options and on strategy that describe

the sources of value in investment projects and

illustrate how rudimentary application of NPV

analysis can understate the value of certain

investments.

PART 3: CAPITAL BUDGETING