Suppose a firm estimates its cost of capital for the coming year at 10%, what are reasonable costs of capital for evaluating average-risk, high-risk, and lo-risk projects?

A Google search of the phrase "reasonable cost of capital" reveals that this question has been plastered all over the internet in exactly the same form. In a few cases, "answers" are available for a few dollars, which I was not willing to pay.

I am not a business school graduate, but seems to me that if a firm is able to borrow funds at 10%, then that is the cost of capital to that company, regardless of the risk of the project that they apply it to.

To determine the reasonable costs of capital for evaluating average-risk, high-risk, and low-risk projects, we need to consider the concept of the risk premium. The risk premium is the additional return required by an investor to undertake a riskier investment compared to a risk-free investment, which is typically represented by the risk-free rate.

The risk-free rate is the estimated return on an investment that carries no risk. Typically, the risk-free rate is derived from the yield of a government bond with a long-term maturity period, such as a 10-year Treasury bond.

Once we have the risk-free rate, we can add an appropriate risk premium to calculate the cost of capital for each type of project. The risk premium varies based on the level of risk associated with the project. Here are some general guidelines:

1. Average-risk projects: These projects are considered to have a moderate level of risk. A common approach to determine the cost of capital for average-risk projects is to add a risk premium of 5-7% to the risk-free rate. Therefore, assuming a risk-free rate of 3%, the cost of capital for average-risk projects would range from 8% to 10%.

2. High-risk projects: High-risk projects are those that involve significant uncertainties or volatility. For such projects, the risk premium should be higher than that for average-risk projects. The cost of capital for high-risk projects can be estimated by adding a risk premium of 8-12% (or even higher) to the risk-free rate. Using the same risk-free rate of 3%, the cost of capital for high-risk projects would range from 11% to 15% or more.

3. Low-risk projects: Low-risk projects typically exhibit stability and predictability in their cash flows. As a result, the risk premium required for low-risk projects is generally lower. A risk premium of 2-4% added to the risk-free rate would be reasonable for low-risk projects. Using the same risk-free rate of 3%, the cost of capital for low-risk projects would range from 5% to 7%.

It's important to note that these ranges are just general guidelines, and the actual costs of capital may vary based on other factors specific to the firm or industry. Additionally, conducting a comprehensive risk analysis and incorporating other relevant factors, such as the firm's financial situation and market conditions, is crucial for determining accurate costs of capital for different types of projects.