In: Categories » Business » Strategic planning » Estimating the Cost and Risk of Capital for Individual Projects
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Although it is intuitively clear that riskier projects have a higher cost of capital, it is difficult to estimate project risk. First, note that three separate and distinct types of risk can be identified: 1. Stand-alone risk is the project’s risk disregarding the fact that it is but one asset within the firm’s portfolio of assets and that the firm is but one stock in a typical investor’s portfolio of stocks. Stand-alone risk is measured by the variability of the project’s expected returns. It is a correct measure of risk only for one-asset firms whose stockholders own only that stock. 2. Corporate, or within-firm, risk is the project’s risk to the corporation, giving consideration to the fact that the project represents only one of the firm’s portfolio of assets, hence that some of its risk effects will be diversified away. Corporate risk is measured by the project’s effect on uncertainty about the firm’s future earnings. 3. Market, or beta, risk is the riskiness of the project as seen by a well-diversified stockholder who recognizes that the project is only one of the firm’s assets and that the firm’s stock is but one part of his or her total portfolio. Market risk is measured by the project’s effect on the firm’s beta coefficient. Taking on a project with a high degree of either stand-alone or corporate risk will not necessarily affect the firm’s 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 venture—its stand-alone 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 the new autos. This means that the project will tend to do well if GM’s other divisions are doing well and will tend to do badly if other divisions are doing badly. This being the case, the project will also have high 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 judgmental manner. The first step is to determine the divisional cost of capital, and then to group 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—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 percent, its managers might use 10 percent to evaluate average-risk projects in the division, 12 percent for high-risk projects, and 8 percent for low-risk projects. While this approach is better than not risk adjusting at all, these risk adjustments are necessarily subjective and somewhat arbitrary. Unfortunately, given the data, there is no completely satisfactory way to specify exactly how much higher or lower we should go in setting risk-adjusted costs of capital.
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