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How to Estimate a Project Specific Discount Rate

How to Estimate a Project Specific Discount Rate
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  • 0:03 Cost of Capital
  • 0:46 How to Use
  • 1:57 Pure Play Approach
  • 2:44 Subjective Approach
  • 3:40 Lesson Summary
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Lesson Transcript
Instructor: Natalie Boyd

Natalie is a teacher and holds an MA in English Education and is in progress on her PhD in psychology.

How do businesses figure out whether or not to invest in a project? In this lesson, we'll examine how to evaluate the returns of a project, including the cost of capital and the pure play and subjective approaches to discounting the cost of capital.

Cost of Capital

Janet is running a clothing business, and she's faced with a problem. She wants to invest some of the company's money in new equipment. This will make her team more efficient and could have a big payoff. On the other hand, the money for the equipment could be invested and earn the company money in another way. What should Janet do?

Cost of capital refers to the amount that invested money could earn if invested in a different asset. For example, the money that Janet wants to invest in new equipment can't be invested elsewhere, like in new training for her staff. The cost of capital is the rate that a business could earn if the company's money is invested somewhere else. In Janet's case, it means somewhere other than new equipment.

How to Use

Many companies use cost of capital as a way of knowing what an investment would need to return to be a good investment. For example, if Janet knows that additional training could earn the company 8% over the next two years, then if the new equipment costs less than 8%, it's a good investment.

The problem with using cost of capital is that it's calculated in part by looking at the risk of the investment and the risk of the company overall. What if the investment is riskier or less risky than the company overall? For example, Janet's company is a pretty risky company. Its returns go up and down pretty dramatically. As such, any investment in Janet's company would need to have a pretty high rate of return to justify the risk.

The equipment Janet wants to buy is for a division of the company that is far less risky than the rest of the company, and also has lower overall returns. The equipment itself is likely not to return very much, compared to other investments that benefit the company at large. Does this mean Janet should abandon her plan? To help her decide, look at two ways of adjusting the cost of capital for a specific project: the pure play approach and the subjective approach.

Pure Play Approach

Janet's company makes clothing and accessories. She wants to invest in new equipment that will allow her accessories division to make belts more efficiently. The accessories division and, even more specifically, the belts, don't have as much risk or reward as the company as a whole.

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