The Subjective Approach

Because of the difficulties that exist in objectively establishing discount rates for individual projects, firms often adopt an approach that involves making subjective adjustments to the overall WACC. To illustrate, suppose a firm has an overall WACC of 14 percent. It places all proposed projects into four categories as follows:

Category	Examples	Adjustment Factor	Discount Rate
High risk	New products	+6%	20%
Moderate risk	Cost savings, expansion of existing lines	+0	14
Low risk	Replacement of existing equipment	-4	10
Mandatory	Pollution control equipment	n/a	n/a

n/a =Not applicable.

The effect of this crude partitioning is to assume that all projects either fall into one of three risk classes or else are mandatory. In the last case, the cost of capital is irrelevant because the project must be taken. With the subjective approach, the firm’s WACC may change through time as economic conditions change. As this happens, the discount rates for the different types of projects will also change. Within each risk class, some projects will presumably have more risk than others, and the danger of making incorrect decisions still exists. Figure 15.2 illustrates this point. Comparing Figures 15.1 and 15.2, we see that similar problems exist, but the magnitude of the potential error is less with the subjective approach. For example, the project labeled A would be accepted if the WACC were used, but it is rejected once it is classified as a high-risk investment. What this illustrates is that some risk adjustment, even if it is subjective, is probably better than no risk adjustment. It would be better, in principle, to objectively determine the required return for each project separately. However, as a practical matter, it may not be possible to go much beyond subjective adjustments because either the necessary information is unavailable or else the cost and effort required are simply not worthwhile.

CONCEPT QUESTIONS

a What are the likely consequences if a firm uses its WACC to evaluate all proposed investments?

b What is the pure play approach to determining the appropriate discount rate? When might it be used?