A corporation’s policy manual states: “Our company’s policy is to use 12%, which

Question

A corporation’s policy manual states: “Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment.” What is wrong with this policy? In what types of projects will this company over invest? In what types of projects will it under invest? A corporation’s policy manual states: “Our company’s policy is to use 12%, which is our cost of capital, as the discount rate for NPV calculations on all projects considered for investment.” What is wrong with this policy? In what types of projects will this company over invest? In what types of projects will it under invest?

Explanation / Answer

This is wrong since all the projects that the company is going to consider can never have similar risk. The required rate of return is directly proportional to the risk of the project and hence risky project needs higher rate of return. In this case all the projects are being provided with the same rate of return. Therefore, risky projects that ideally should have higher rate of return are providing lower return and vice versa. There is also a possibility that some projects might be non feasible but company invested in them since rate of return used is just 12%. The company will therefore overinvest in the risky projects. For less projects, lower rate of return is imminent. But when compared with 12%, which is as per the company’s policy, the project might not be able to deliver the same. The company will, hence, underinvest in less risky projects.

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