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    Determining project value: cost of capital right for all firms?

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    When a firm uses cost of capital to evaluate all projects, it would overestimate the value of high risk projects. The cost of capital is usually an estimate of return for average-risk projects. When evaluating high risk projects, firm should discount the project cash flows with a higher cost of capital. An example is Microsoft as it is a well-known company in the computing industry for its software products. Microsoft earns a good line of cash flows from its flagship products like Microsoft Office suite, Internet Explorer web browser and Windows Server System line. Hence, investors know that the company has reliable cash flows due to which cost of capital for the company is low. However if Microsoft decides to buy an unrelated company like Kia Motors and produce Microsoft cars, the cash flows from this project would not be reliable at all as compared to cash flows from its core products. It is because Microsoft is not associated with cars and they have no knowledge about manufacturing cars or selling them. If projected sales and profits from the car project are discounted with cost of capital based on core products, it would give a very high number than if it was discounted with a higher discount rate to compensate for the risk of such project. It does seem as though the value of projects could easily be overestimated in similar situations like this. This is actually a pretty common scenario in many companies also. With the every changing economy and technological advances, it seems as though companies are constantly trying to cross markets in order to ensure they are versatile. It allows them to get their name out to more markets and increases their ability to be innovative across many market segments. Although, it seems as though most companies do their proper research and are able to be successful with this type of approach there seem to be many that fail as well.
    1. What do you think about this type of movement for a company?
    2. 2.How would you go about projecting the value of a project and whether or not it is right for your company?
    3. What factors would you consider?

    © BrainMass Inc. brainmass.com December 24, 2021, 11:37 pm ad1c9bdddf
    https://brainmass.com/business/management-accounting/project-value-cost-capital-right-firms-586882

    SOLUTION This solution is FREE courtesy of BrainMass!

    1. What do you think about this type of movement for a company?

    I think this is sensible. Using the cost of capital as the discount rate on all new capital projects doe treat all future cash flows as equally likely. This would rarely be the case since some cashflows are more certain than others. For existing products with established demand, the forecasts may be fairly predictable. For a new product with no known demand, the forecasts can be erratic and closer to educated guesses. So, using a range of discount rates, from cost of capital to much higher rates, can adjust for levels of uncertainty. What this does is reduce the value of highly uncertain future cash flows when the assumptions used are very tenative.

    2.How would you go about projecting the value of a project and whether or not it is right for your company?

    You would project the value of the project based on estimated future cash flows, but with a varying discount rate based on the qualitative judgment on how well the assumptions are understood. This could be a tier system, such as "solid history or data for assumptions" = cost of capital, "limited history or data" = cost of capital plus 5%, or "little history or data" cost of capital plus 10%. This would require the managers to decide how solid the assumptions for the capital investment are - not a bad idea! All assumptions are not equal. This would force the conversation about what assumptions are made and based on what data. That's healthy.

    3. What factors would you consider?
    I would consider the expertise of the manager(s) that will implement the project, the amount of experience with the product, the extent of market knowledge about the customers, the level of activity for substitutes, the length of the project (longer is more risk) and the risk tolerance of the firm (culture). I would also consider potential threats to the project (competition, price changes, shortages, shipping costs). The more uncertainty in the situation, the more likely the project would be bumped up to a higher level of risk assessment and therefore a higher discount rate to discount the future cash flows to the present value to determine the value of the project.

    Your discussion is 336 words and explains a tier system for evaluating a project value.

    This content was COPIED from BrainMass.com - View the original, and get the already-completed solution here!

    © BrainMass Inc. brainmass.com December 24, 2021, 11:37 pm ad1c9bdddf>
    https://brainmass.com/business/management-accounting/project-value-cost-capital-right-firms-586882

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