68.7. ASSESSMENT OF PROJECT RISK IN PRACTICE

Most U.S. companies consider risk in some manner in evaluating investment projects. But considering risk is usually a subjective analysis as opposed to the more objective results obtainable with simulation or sensitivity analysis.

Surveys indicate that companies that use discounted cash flow techniques, such as net present value and internal rate of return methods, tend to use a risk-adjusted cost of capital, but generally use the company's weighted average cost of capital as a benchmark. (See, for example, the survey by Graham and Harvey [1977].) But a significant portion of companies use a single cost of capital for all projects, which can be problematic. Suppose a company uses the same cost of capital for all its projects. If all of them have the same risk and the cost of capital being used is appropriate for this level of risk, there is no problem. But what if a company uses the same cost of capital but the projects each have different levels of risk?