Single vs. Multiple Discount Rates: How to Limit 'Influence Costs' in the Capital Allocation Process
Posted: 11 Sep 2008
Date Written: September 9, 2008
A widely cited survey of financial executives reported that more than 50% of the surveyed companies used a single, company-wide discount rate to evaluate all investment proposals. The shortcomings of this approach are well known and reported in virtually every introductory finance text. Yet despite technological improvements and the legions of MBAs who are fully aware of the importance of matching project risk with risk-adjusted discount rates, corporate executives tend to prefer evaluating investment opportunities using very simple approaches that provide managers with very few degrees of freedom.
In this article we discuss political and organizational problems that tend to discourage the use of multiple discount rates. More importantly, we provide a relatively straightforward method for choosing discount rates that captures much of the differences in the risk of individual investment projects while at the same time limiting the effect of these organizational impediments to risk-adjusted capital budgeting.
Keywords: Cost of Capital, Influence Costs
JEL Classification: G31
Suggested Citation: Suggested Citation