A company's Weighted Average Cost of Capital (WACC) — which is the rate of return required by investors in the company's securities — is the appropriate discount rate to use in capital budgeting decisions and NPV calculations as long as the riskiness of the project is the same as the riskiness of the firm's existing business. When the riskiness of the project is different from that of the company's existing business, the discount rate used to calculate NPV needs to be adjusted to reflect the changed risk profile of the firm as a result of the project under consideration. A higher discount rate is used to reflect higher risk; a lower discount rate reflects lower risk. And when the risks of the individual components of a project's cash flows are different, it is appropriate to use a risk-adjusted discount rate for each component that is specific for the degree of risk inherent in that component of the cash flow.
The internal rate of return is the discount rate at which the NPV is zero. It is not used in evaluating risk.
The payback period is not relevant to evaluating risk in cash flows.
The firm's cost of capital is the appropriate discount rate to use in capital budgeting decisions and NPV calculations only if the riskiness of the project is the same as the riskiness of the firm's existing business. When the riskiness of the project or of any individual component of the project's cash flow is different from that of the company's existing business, the discount rate used to calculate NPV needs to be adjusted to reflect the changed risk profile of the firm as a result of the project under consideration.
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