The rate at which a company should discount risky cash flows when making a capital investment decision should be the rate that its shareholders would use if they were investing directly in the project.
The company is entrusted with the shareholders’ money and charged with increasing its shareholders' wealth. When the company invests in assets, the shareholders are indirectly investing in assets. The company should decide whether to invest in an asset the same way the shareholders would decide. Given the principles of diversification and the CAPM, we know how our shareholders would think if they were considering investing in the same project that we, the company’s management, are considering investing in for the company. Therefore, we should evaluate the decision the same way the shareholders would.
Thus, the discount rate on the project should be the same as it would be if the project traded like a stock. To estimate this rate, we might consider estimating the project’s beta and using the CAPM to obtain the expected return. Alternatively, we might search for a publicly traded company that is similar to the project in question and use the return its shareholders expect.
Although this statement refers to "risky" cash flows, it also applies to risk-free cash flows, because shareholders would discount risk-free cash flows at the risk-free rate, which is the rate the company should use.
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Last updated: January 9, 2011