Improving Capital Budgeting: Why One Discount Rate May Not Fit All

What is it about?

Companies use capital budgeting to decide whether long-term investment projects are worth undertaking. Finance textbooks commonly teach that a project's net cash flows should be discounted using the firm's weighted average cost of capital (WACC). This approach assumes that all of the project's cash flows have the same level of systematic risk. In practice, however, operating cash flows and future investment outlays can have very different risks. This study explains why using a single discount rate may therefore produce misleading project values and proposes using separate discount rates that better reflect the risk of each type of cash flow.

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Why is it important?

Capital budgeting decisions can involve large investments with consequences lasting many years, so accurately valuing future cash flows is important. Traditional textbook methods generally combine a project's operating cash flows and future investment outlays and discount the resulting net cash flows at a single rate. This study shows why that approach may be inappropriate when the two types of cash flows have different systematic risks. We propose discounting operating cash flows at the firm's WACC, or another rate reflecting their systematic risk, while discounting expected future investment outlays at the risk-free rate when their systematic risk is effectively zero. The proposed approach provides a theoretically grounded and practical way to improve project valuation.

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