Question

If a prospective project has a risk level greater than the average risk project in the company, should the company evaluate the prospective project with the company's current cost of capital? Explain.

Answer 1

If a prospective project has a risk level which is higher than the normal projects then a company should be using the risk weighted cost of capital than the normal cost of capital of the company.

The risk weighted cost of capital accounts for different level of risk associated with the project and then discount the product with the same risk weight and that will help the project to be evaluated fairly in order to be accepted or rejected.

risk weighted average cost of capital helps in determination of various kind of risk assignment to the cost of capital, which is specific in nature and then discounting the projects with those risk assigned weights will help in better analysis of whether to accept the project or reject the project.

So a company should not use the current cost of capital to evaluate a prospective project because it can lead to unfair evaluation.