What are the two distinct schools of thought regarding the use of discounting rates in capital budgeting?

The two distinct schools of thought regarding discounting rates in capital budgeting are: one that focuses on internal efficiency using the weighted average cost of capital (WACC) as the discounting rate, and another that emphasizes earning a fair rate of return, incorporating project-specific risk factors into the discounting process.

The first school of thought advocates for using the weighted average cost of capital as the discounting rate, arguing that it reflects the return suppliers of funds expect. This approach suggests that projects with a positive net present value (NPV) are acceptable as they meet the minimum cash flow requirements. The second school of thought contends that a project should earn a fair rate of return, which considers not only the cost of funds but also additional risks specific to the project, collectively known as the risk premium. This perspective aims to evaluate investments based on their unique characteristics and market perceptions of fair returns.