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BUS 313

Which rate fits this project?

Split the firm into debt and equity, average their costs into the company's rate, then see why each project needs a rate that matches its own risk, not the company's.

Part 1 · The company's cost of capital · Step 1 of 10

One company, many projects: each needs a rate that fits its risk

Illustration: discount rates by kind of project
0%10%20%30%40%discount rate (%)SpeculativeventuresNewproductsExpansionsame businessCost cutsknown tech30%20%15%10%
company's rate, 15%the project's expected return (IRR), 12%
An illustration only: a real project’s rate comes from its own risk.
A company’s cost of capital is the return its investors could earn elsewhere on investments as risky as the company as a whole. But one project can be safer or riskier than the company. The right discount rate for a project is the return on investments with the project’s own risk. In the illustration below, risky bets need high rates, safe cost-cutting needs a low one, and the company’s own rate sits in the middle.
Try it: Pick Speculative and set the expected return to 22%. The company's rate says yes; the project's own rate says no.
Kind of project
Project's expected return (IRR)12%
Rate for this kind of project
10%
Company's rate
15%
Right decision
accept
The company's 15% says reject. But this project is safer than the company: its own risk only calls for 10%, and it is expected to earn 12%, so its NPV is positive. A good project wrongly rejected.
Right rule: 12% vs 10% → accept
Compare the expected return with the rate for the project's own risk.
Company-rate shortcut: 12% vs 15% → reject
One rate for every project ignores how risky each one is.
Check yourself
A company's cost of capital is 12%. It is looking at a very safe cost-cutting project. The right discount rate for that project is most likely…

Midterm coming up and the cost of capital still feels slippery?

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