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21 Apr 2018

A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest?

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Hubert Koch
Hubert KochLv2
22 Apr 2018

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A. )

Several methods are available to deal with the issue of differing levels of project risk. These include risk adjusted discount rates, simulation analysis, scenario analysis, and break-even analysis. Which of these would you favor if you were CFO of a corporation? Why? Which of the techniques seems like it would yield the most accurate results? Which would be easiest to implement? Elaborate and Explain please

B.)

A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest? Elaborate and Explain please

I first considered what this message was conveying. This policy essentially assumes that all projects are equal, without taking into account that the level of risks will vary between projects. Each project should have its own discount rate when taking into account all the risks or that specific project. This companies policy would result in overinvesting in projects that should actually have a higher discount rate, and underinvesting in projects that should actually have a lower discount rate. In my organization, there are many projects that the project group tackles and each project is treated as its own entity with its own engineers, managers and employees as well as its own budget. This RESPONSE is based on the question: A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest?

WHAT ARE YOUR THOUGHTS ON THE RESPONSE? ELABORATE AND EXPLAIN

A.)A corporation’s policy manual states: "Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment." What is wrong with this policy? In what types of projects will this company overinvest? In what types of projects will it underinvest?

In my opinion: This is wrong since all the projects that the company is going to consider can never have similar risk. The required rate of return is directly proportional to the risk of the project and hence risky project needs higher rate of return. In this case all the projects are being provided with the same rate of return. Therefore, risky projects that ideally should have higher rate of return are providing lower return and vice versa. There is also a possibility that some projects might be non feasible but company invested in them since rate of return used is just 12%. The company will therefore overinvest in the risky projects. For less projects, lower rate of return is imminent. But when compared with 12%, which is as per the company’s policy, the project might not be able to deliver the same. The company will, hence, underinvest in less risky projects.

What do you think? Elaborate and Explain!!

B.)

Please view this short video on capital budgeting. Too basic? Anything new that you learned from it? Please share your thoughts. https://www.youtube.com/watch?feature=player_detailpage&v=kFyZkXHit_A (copy and paste the link in your browser)

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