suppose a firm uses its company cost of capital to evaluate all of its projects. will it underestimate or overestimate the npv of new projects that are riskier than the firm’s average projects?
When a firm uses its company cost of capital to evaluate all of its projects, it assumes that all projects have the same level of risk as the firm’s average projects. If the firm’s average projects are less risky than the new projects being evaluated, then using the company cost of capital would lead to underestimation of the NPV (Net Present Value) of the new projects.
This is because the company cost of capital represents the minimum rate of return required by the firm’s investors to compensate for the level of risk associated with the average projects. If new projects have higher risk profiles, they would require a higher rate of return to compensate for that increased risk. However, since the company cost of capital is based on the firm’s average risk, it may not adequately capture the higher level of risk associated with the new projects. As a result, the NPV of the new projects would be underestimated.
Underestimating the NPV of riskier projects can lead to potential missed investment opportunities. It’s important for firms to incorporate the appropriate risk adjustments in their project evaluations to ensure accurate estimations of the projects’ NPV and make informed investment decisions. One way to address this issue is by adjusting the discount rate or cost of capital to reflect the risk profile of each individual project.