Info

Mandatory

Pollution control equipment

n/a

n/a

n/a = Not applicable.

n/a = Not applicable.

The effect of this crude partitioning is to assume that all projects either fall into one of three risk classes or else are mandatory. In the last case, the cost of capital is irrelevant because the project must be taken. With the subjective approach, the firm's WACC may change through time as economic conditions change. As this happens, the discount rates for the different types of projects will also change.

Within each risk class, some projects will presumably have more risk than others, and the danger of making incorrect decisions still exists. Figure 15.2 illustrates this point. Comparing Figures 15.1 and 15.2, we see that similar problems exist, but the magnitude of the potential error is less with the subjective approach. For example, the project labeled A would be accepted if the WACC were used, but it is rejected once it is classified as a high-risk investment. What this illustrates is that some risk adjustment, even if it is subjective, is probably better than no risk adjustment.

It would be better, in principle, to objectively determine the required return for each project separately. However, as a practical matter, it may not be possible to go much beyond subjective adjustments because either the necessary information is unavailable or else the cost and effort required are simply not worthwhile.

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