Suppose a firm estimates its cost of capital for the coming year to be 10 percent. What are reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk projects? Please help .
This question was posted last week and has been posted all over the internet. We have no way of answering it becasue the level of risks are not quantitatively defined, and because the cost of capital TO A COMPANY is whatever the banks or bond market say it is (10% here), regardless of the risk level assigned internally by the company.
What if I just picked an operating capital of say 2M and used the current rates on low and high risk bonds added to the 10%, would this give me an answer for the three situtations?
The amount of your operating capital should not matter. In a related answer, Ms Sue has wisely said that a company should require a lower cost of capital to justify higher-risk projects.
If you use a phrase from your question for a google search, you will see that it has been posted verbatim at many Q&A sites. Some have provided answers, for a small fee. You are welcome to explore them.
Thanks.
a firm estimates its cost of capital for the coming year to be 10 percent.
To determine the reasonable costs of capital for evaluating projects with different degrees of risk, you can make use of the concept of the risk premium and the Capital Asset Pricing Model (CAPM).
The cost of capital is the rate of return required by investors to invest in a company or a project, and it typically consists of two components: the risk-free rate and the risk premium.
The risk-free rate is the expected return on an investment that carries no risk, such as a government bond. To find the risk-free rate, you can look at the yield of government bonds with similar terms as the project.
The risk premium represents the additional return that investors demand to compensate for taking on the risk of investing in a particular project. The risk premium varies depending on the project's riskiness and can be estimated using the CAPM.
The CAPM formula is:
Expected Return on Equity = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate)
Where:
- Risk-Free Rate: The risk-free rate obtained from government bond yields.
- Beta: A measure of the project's sensitivity to market movements. A higher beta indicates higher project risk.
- Market Return: The expected return of the overall market.
Based on the above information, the reasonable costs of capital for evaluating average-risk, high-risk, and low-risk projects can be estimated as follows:
1. Average-risk projects:
For average-risk projects, the beta is typically assumed to be 1.0. Thus, you would use the risk-free rate, which you can obtain from government bond yields, and add the average market return to it.
2. High-risk projects:
For high-risk projects, the beta value is typically greater than 1.0. Use the same risk-free rate but adjust the risk premium by adding a higher multiple of the market return to it. The multiple can be determined based on the project's higher risk level.
3. Low-risk projects:
For low-risk projects, the beta value is typically less than 1.0. Again, use the same risk-free rate but adjust the risk premium by adding a lower multiple of the market return to it. The multiple can be determined based on the project's lower risk level.
Remember, cost of capital estimates are subjective and depend on many factors, including the industry, economic conditions, and company-specific risk. It is essential to assess these factors and to consult with financial professionals to obtain more accurate estimates for your specific situation.