Corporate Finance 571
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When a firm chooses to use a single discount rate to compute NPV in all its possible capital budgeting projects .That have wide range of non-diversifiable risks, it is bound to get riskier. This method has many drawbacks and the main harm it imposes is on diversified risks and projects lower risk it means the firm has to choose from inflation rate, interest rate or any desired rate of return (Baker, 2017). This means the projects shall have an internal rate of return that makes the net present value of all the cash flows from the project to be zero. Therefore when the IRR of the project is higher than the cost of capital the NPV of the project shall be positive whereas when it is lower than the cost of capital, the NPV of the project shall be negative (Parrino, 2015).
The firm may be selecting projects that have higher IRR than the single discount rate which are riskier. A single discount rate brings about negatives to a project with higher and undiversifiable risks on ta project that has a relative lower risks. This hides the risk of the projects that are seen to be risky and makes the project to appear less risky than the reality. Alternatively, it does the harm to the less risky projects since it shows them a more risky and less diversified than the actual Since they bring the risk of the other projects to be seen within the project that are less risky.
Therefore, the general risk profile of the firm with the project becomes less likely to depict in a transparent way and make the fir, to appear riskier to the investors as well as the associates (Parrino, 2015). Normally, when a firm wants to decide the rate to be used to discount its future cash flows, is it considers the risk associated with that project and the cost of financing. Therefore the discount rate should engross the risk factor.
In conclusion it would not be advisable for the firm to use one single discount rate in all types of projects.
References
Capital Budgeting Valuation: Financial Analysis for Today’s Investment Projects.” Capital
Budgeting Valuation: Financial Analysis for Today’s Investment Projects – Baker – Wiley Online Library. N.p., n.d. Web. 20 Feb. 2017.
Parrino, R. (2015). Corporate Finance. Singapore: John Wiley & Sons.
