Single vs. Multiple Discount Rates: How to Limit Influence Costs in the Capital Allocation Process

7 Pages Posted: 17 Jul 2008

See all articles by John D. Martin

John D. Martin

Baylor University - Department of Finance, Insurance & Real Estate

Sheridan Titman

University of Texas at Austin - Department of Finance; National Bureau of Economic Research (NBER)

Abstract

This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the influence costs that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm-wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project-specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating. Most finance textbooks suggest that companies evaluate investment projects using discount rates that reflect both the debt capacity and the unique risks of the project. In practice, however, companies often use their company-wide WACC to evaluate such investments because of the difficulty of (and subjectivity involved in) estimating the risk of individual projects, and the potential for managerial bias and influence to distort the estimates. This article proposes a practicable method for calculating the cost of capital that produces different discount rates for investment projects with different risks while minimizing the influence costs that arise when managers have discretion in the choice of discount rates. The proposed approach makes use of market information (in the form of the firm-wide costs of debt and equity), thereby limiting managerial discretion, while typically still providing a good approximation of theoretically correct, project-specific discount rates. The key to the method's effectiveness is its use of a project's debt capacity to define the capital structure weights, where debt capacity is defined by the amount of debt financing the project will support without lowering the firm's credit rating.

Suggested Citation

Martin, John D. and Titman, Sheridan, Single vs. Multiple Discount Rates: How to Limit Influence Costs in the Capital Allocation Process. Journal of Applied Corporate Finance, Vol. 20, Issue 2, pp. 79-83, Spring 2008. Available at SSRN: https://ssrn.com/abstract=1161947 or http://dx.doi.org/10.1111/j.1745-6622.2008.00182.x

John D. Martin (Contact Author)

Baylor University - Department of Finance, Insurance & Real Estate ( email )

P.O. Box 98004
Waco, TX 76798-8004
United States
254-710-4473 (Phone)
254-710-1092 (Fax)

HOME PAGE: http://hsb.baylor.edu/html/martinj

Sheridan Titman

University of Texas at Austin - Department of Finance ( email )

Red McCombs School of Business
Austin, TX 78712
United States
512-232-2787 (Phone)
512-471-5073 (Fax)

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

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