D. D. Ronnelley Co. is a conglomerate firm with operations in publishing and computer software. It is considering whether to accept a new project in computer software. Noting that publishing is a low-beta business while computer software is a high-beta business, the conglomerate firm realizes it should discount the project at a rate commensurate with the risk of computer software. Instead, if all projects in D. D. Ronnelley Co. were discounted at the same rate, a bias would result. The firm would accept too many high-risk projects (software ventures) and reject too many low-risk projects (books and magazines). This point is illustrated in Figure 13.5. Figure 13.5 Relationship between the Firm’s Cost of Capital and the Security Market Line (SML)

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Discount rate for project Firm's overall cost of capital RF Accept unprofitable, high-risk project Reject profitable, low-risk project SML Beta of project A single cost of capital for all projects in a firm, as indicated by the horizontal line in the figure, may lead to incorrect capital budgeting decisions. Projects with high risk, such as the software venture for D. D. Ronnelley Co., should be discounted at a high rate. By using the firm's cost of capital, the firm is likely to accept too many high-risk projects. Projects with low risk should be discounted at a low rate. By using the firm's cost of capital, the firm is likely to reject too many low-risk projects.