Tantasqua Paper Products is composed of 3 divisions: industrial paper products, commercial paper products, and a forestry division which grows trees for wood pulp used in the paper-making process
Each of these divisions takes on a large number of projects with differing risk characteristics. Tantasqua now uses a single discount rate based on the company's WACC to evaluate all capital budgeting proposals. Discuss the advantages and disadvantages of switching to an approach based on separate discount rates for each division or even the risk level of each project.
Answer: Switching to multiple discount rates may lead to better capital budgeting decisions because it matches the discount rate used to the unique risk characteristics of each project or division. Tantasqua would then be less likely to reject good projects that offered relatively low rates of return but with very little risk or to accept projects with too much risk for the rate of return implied by the discount rate.
On the other hand, trying to match discount rates to each individual project might be time consuming and often somewhat subjective. The benefits of such an attempt might not be commensurate with the costs. Using a WACC tailored to each of the three divisions is a more practical approach, but also not without its problems. In particular, it might be difficult to find good free-standing comparable companies needed to implement the "pure play" approach.
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