Capital budgeting project: Discount rate

(Question)
We are making inappropriate investment decisions since the discount rate used to evaluate all potential projects is the firm's weighted average cost of capital.

Which of the following would best correct the discount rate problem described in the statement above?

A. Use the firm's marginal cost of capital to evaluate all potential projects.
B. Use a beta specific to each potential project to determine the appropriate discount rate.
C. Use the cost of firm's equity capital to discount the cash flows of all potential subjects.

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Answer: B

When evaluating potential capital investment projects, the discount rate should be adjusted for the risk of the project under consideration. This is frequently accomplished by determining a project beta and using this beta in the CAPM security market line equation: r_i = R_F + β_i[E(R_M)-R_F]. Project betas can be determined in a number of ways including using proxy firms with operations similar to the project under consideration, estimating an accounting beta, or through cross-sectional regression analysis. Whatever method used to determine the discount rate, it should be clear that the weighted average cost of capital (WACC) is only appropriate for projects with risk similar to the overall firm. If a project is more (less) risky than the overall firm, the discount rate used to evaluate the project should be greater (less) than the firm's WACC.