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Published on March 30, 2021 12 min
Other Talks in the Series: Finance for Non-Finance Professionals
Hello, I'm Professor Michael McDonald. When we're talking about finance, one of the key areas is what we call 'project selection'.
Project selection is perhaps the most visible, or the most interesting and exciting part of corporate finance. Project selection involves making investment decisions on behalf of a firm. Examples involving project selection being things like expanding a plant or a factory, opening a new store location, buying out a competitor, investing in R&D. Any big decision a company makes often comes down to what we refer to as project selection. Finding and identifying these opportunities to invest in the business, then deciding whether or not to make that investment. That's what project selection is all about.
When we're trying to decide which opportunities a company should capitalize on, we have to evaluate the different projects. We evaluate these projects based on their projected cash-flows and then discount rate for the firm. The firm's discount rate reflects the risk at the company, as well as the risk of the project itself. For instance, if we have two different companies, one of them being, say, a start-up firm and one being a well-established firm, if both companies are looking at expanding a facility. The discount rate for the start-up company is probably going to be a lot higher, because that firm's risk is a lot higher than for the established firm. Similarly, if we have a single firm, firm ABC, and they're thinking about two different projects, one project might be (as an example, say) a new marketing endeavor involving an existing project. The other one might be a long-term research and development project, with a lot of risk involved. That R&D project should have a higher discount rate than the simple safe marketing effort. The idea is that the discount rate reflects the level of risk in the project, as well as the level of risk for the firm overall. Corporate finance, when it comes to project selection, is all about trying to figure out how certain we are about these cash flows that will come down the road, and then what rate or discount rate we should use to discount those cash flows at. If we're very uncertain about the cash flows, then we need to heavily discount them to take into account the fact that we're not sure if they'll materialize. In contrast, if we're pretty confident that those cash flows are going to come about as we expect, then we can use a low discount rate. That's the idea.