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Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation Process *

Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation... Most finance textbooks suggest that companies evaluate investment projects using discount rates that reflect both the debt capacity and the unique risks of the project. In practice, however, companies often use their company‐wide WACC to evaluate such investments because of the difficulty of (and subjectivity involved in) estimating the risk of individual projects, and the potential for managerial bias and influence to distort the estimates. This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the “influence costs” that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm‐wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project‐specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating. http://www.deepdyve.com/assets/images/DeepDyve-Logo-lg.png Journal of Applied Corporate Finance Wiley

Single vs. Multiple Discount Rates: How to Limit “Influence Costs” in the Capital Allocation Process *

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Publisher
Wiley
Copyright
Copyright © 2008 Morgan Stanley
ISSN
1078-1196
eISSN
1745-6622
DOI
10.1111/j.1745-6622.2008.00182.x
Publisher site
See Article on Publisher Site

Abstract

Most finance textbooks suggest that companies evaluate investment projects using discount rates that reflect both the debt capacity and the unique risks of the project. In practice, however, companies often use their company‐wide WACC to evaluate such investments because of the difficulty of (and subjectivity involved in) estimating the risk of individual projects, and the potential for managerial bias and influence to distort the estimates. This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the “influence costs” that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm‐wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project‐specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating.

Journal

Journal of Applied Corporate FinanceWiley

Published: Mar 1, 2008

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