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?
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Solution Summary
Your discussion is 336 words and explains a tier system for evaluating a project value.
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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, ...
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