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IAI Actuarial Core Principles · Business Finance · Cost of capital and evaluating investment projects

A manufacturer is evaluating a project in an area unrelated to its existing business, whose equity beta differs from the firm's. Which is the most appropriate way to set the discount rate?

Use a discount rate built from the beta of comparable firms operating in the project's industry, adjusted for the project's gearing. The firm's existing WACC reflects the old business's risk, so using it would misprice a project with different systematic risk.

  1. AUse the firm's existing weighted average cost of capital regardless of the project's risk
  2. BUse a rate based on the beta of comparable firms in the project's industry, adjusted for the project's financingCorrect
  3. CUse the risk-free rate because the project is separate
  4. DUse the firm's cost of debt only
  5. Use the highest historical return the firm has earned

Explanation

Where project risk differs from the firm's existing business, the firm's WACC is not appropriate. A proxy beta from comparable listed firms in the new industry, de-geared and re-geared for the project's capital structure, gives a rate that reflects the project's systematic risk.

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