Unformatted text preview: he internal
rate of return, and use this one rate? You will end up:
• rejecting profitable projects (which would have increased owners' wealth) that have risk below
the risk of the average risk project because you discounted their future cash flows too much, and • accepting unprofitable projects whose risk is above the risk of the average project, because you
did not discount their future cash flows enough. Companies that use a risk-adjusted discount rate usually do so by classifying projects into risk classes by
the type of project. For example, a company with a cost of capital of 10 percent may use a 14 percent
cost of capital for new products and a much lower rate of 8 percent for replacement projects. Given a set
of costs of capital, the financial manager need only figure out what class a project belongs to and then
apply the rate assigned to that class.
Companies may also make adjustments in the cost of capital for factors other than the type of project.
For example, companies investing in projects in foreign countries will sometime...
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- Spring '07