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Cost of Capital for Individual Projects

Cost of Capital for Individual Projects

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It is useful to consider how project risk is reflected in measures of the firm’s cost of capital. First, although it is intuitively clear that riskier project have a higher cost of capital; it is difficult to measure projects’ relative risks.
It is useful to consider how project risk is reflected in measures of the firm’s cost of capital. First, although it is intuitively clear that riskier project have a higher cost of capital; it is difficult to measure projects’ relative risks.

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Finance

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Cost of Capital for Individual Projects
It is useful to consider how project risk is reflected in measures of the firm’s cost of capital. First, although it is intuitively clear that riskier project have a higher cost of capital; it is difficult to measure projects’ relative risks. Also, note that three separate and distinct types of risk can be identified as follows. 1. Stand-alone risk - which is the variability of the project’s expected returns 2. Corporate, or within-firm, risk, which is the variability the project contributes to the corporation’s returns, giving consideration to the fact that the project represents only one asset of the firm’s portfolio of assets and so some of its risk will be diversified away 3. Market, or beta, risk, which is the risk of the project as seen by a well diversified stockholder who owns many different stocks. A project’s market risk is measured by its effect on the firm’s overall beta coefficient Taking on a project with a high degree of either stand-alone or corporate risk will not necessarily increase the corporate beta. However, if the project has highly uncertain returns and if those returns are highly correlated with returns on the firm’s other assets and with most other assets in the economy, then the project will have a high degree of all types of risk. For example, suppose General Motors decides to undertake a major expansion to build electric autos. GM is not sure how its technology will work on a mass production basis, so there is much risk in the

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venture—its standalone risk is high. Management also estimates that the project will do best if the economy is strong, for then people will have more money to spend on automobiles. This means that the project will tend to do well if GM’s other divisions are doing well but will do poorly if other divisions are doing poorly. This being the case, the project will also have a high degree of corporate risk. Finally, since GM’s profits are highly correlated with those of most other firms, the project’s beta will also be high. Thus, this project will be risky under all three definitions of risk. Of the three measures, market risk is theoretically the most relevant because of its direct effect on stock prices. Unfortunately, the market risk for a project is also the most difficult to estimate. In practice, most decision makers consider all three risk measures in a subjective manner. The first step is to determine the divisional cost of capital before grouping divisional projects into subjective risk categories. Then, using the divisional WACC as a starting point, risk-adjusted costs of capital are developed for each category. For example, a firm might establish three risk classes—high, average, and low—and then assign average-risk projects the divisional cost of capital, higher-risk projects an above-average cost, and lower-risk projects a below-average cost. Thus, if a division’s WACC were 10%, its managers might use 10% to evaluate average -risk projects in the division, 12% for high-risk projects, and 8%for low-risk projects. Although this approach is better than ignoring project risk, these adjustments are necessarily subjective and somewhat arbitrary.

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