What is the danger of applying one cost of capital to all proposed capital budgeting projects?
Not all capital budgeting projects are of the same risk or time horizon. The Fisher model of interest rates tells us that investor’s required rates of return depend on the forecast inflation (a function of time horizon) and risk. As a result, each capital budgeting project has its own hurdle rate, a cost of capital appropriate for its particular combination of time and risk. Applying one cost of capital to all proposed projects runs the risk of making poor decisions: rejecting value-adding low-risk projects and accepting nonvalue-adding high risk projects.