Which Interest Rate for Evaluating Projects?

Abstract: Selecting the interest rate for evaluating potential projects is a key part of the capital budgeting problem. Approaches include (1) the marginal or weighted average cost of capital (WACC), (2) the opportunity cost of capital (from IRR ranking), (3) the theoretically optimal intersection of the first two, (4) risk adjusted rates for equity from capital asset pricing theory—which are usually folded into the WACC as the equity component of the WACC, and (5) portfolio selection models with organizational and political factors. This article describes each approach's theoretical basis, strengths, and weaknesses. The article then attempts to reconcile these disparate approaches into a practical and theoretically sound approach to the project selection problem.