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Question

Which of the following best describes the discount factor used in capital investment decision-making ?

A The current inflation rate Correct Answer Incorrect Answer
B The current interest rate Correct Answer Incorrect Answer
C The opportunity cost of capital of all businesses in the same industry Correct Answer Incorrect Answer
D The opportunity cost of capital of business Correct Answer Incorrect Answer
E LIBOR rate Correct Answer Incorrect Answer

Solution

The discount factor used in capital budgeting is the rate of return that a company could earn by investing in another project or security of similar risk. This rate is considered as the opportunity cost of capital for the business. It is the rate that investors could earn elsewhere on investments with similar risks. Therefore, the discount rate is used to evaluate the profitability of the investment opportunity by discounting the future cash flows back to their present value.

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