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Single Discount Rate for NVP & Straight-Line Depreciation

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1) A firm uses a single discount rate to compute the NPV of all its potential capital budgeting projects, even though the projects have a wide range of nondiversifiable risk. The firm then undertakes all those projects that appear to have positive NPVs. Briefly explain why such a firm would tend to become riskier over time.

2) Phyllis believes that the firm should use straight-line depreciation for a capital project because it results in higher net income during the early years of the project's life.

Joanna believes that the firm should use the modified accelerated cost recovery system depreciation because it reduces the tax liability during the early years of the project's life. Assuming you have a choice between depreciation methods, whose advice should you follow? Why?

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Solution Summary

This solution explains why a firm would become risker over time and why using one type of depreciation for a capital project would be the best choice.

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1. A firm uses a single discount rate to compute the NPV of all its potential capital budgeting projects, even though the projects have a wide range of non-diversifiable risk. The firm then undertakes all those projects that appear to have positive NPVs. Briefly explain why such a firm would tend to become riskier over time.

The firm would tend to be riskier over time because the discount rate used would change as the risk on the projects would increase with the passage of time. Also the ...

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Jayant Kumar, MBA
Education
  • MBA, Indian Institute of Finance
  • Bsc, Madras University
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