Capital budgeting techniques: a proposal for improvement

Purpose This paper addresses issues related to the coverage of capital budgeting techniques in textbooks. We propose revisions to better reflect real-world situations. Design/methodology/approach We examine the capital budgeting techniques presented in financial management textbooks published by major U.S. publishers, focusing on the types of cash flows and discount rates. Based on this review, we propose improvements to traditional capital budgeting techniques. Findings Textbooks typically evaluate a project's net cash flows using the firm's weighted average cost of capital (WACC). This method is valid only when the project's net cash flows have the same systematic risk as the firm's net cash flows. However, this assumption often does not hold. We propose using dual discount rates for the project's operating cash flows and expected future investment outlays. Specifically, the project's operating cash flows should be discounted at the firm's WACC or at a rate that reflects the systematic risk associated with those cash flows. The future investment outlays should be discounted at the risk-free rate, considering their systematic risk, which is likely to be zero. Originality/value This paper contributes to the field of capital budgeting techniques by providing a theoretical foundation and a practical case for using dual discount rates in cash flow evaluation.