New Study by Turner College's Gisung Moon Examines Capital Budgeting Techniques Presented in Financial Management Textbooks

A new study by Turner College finance professor Gisung Moon and Hongbok Lee of Western Illinois University examines 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, and then proposes improvements to traditional capital budgeting techniques. The study finds that 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. To address this, Moon and Lee 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. The analysis by Moon and Lee, which is set to appear in an upcoming issue of Managerial Finance, 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.