Monday, April 19, 2010


Divisional and Project Cost of Capital

We emphasize that the required rate of return, or the cost of capital is a market determined rate and it reflects compensation to investors for the time value of money and risk of the investment project. It is, thus, composed of a risk free rate (compensation for time) plus a risk premium rate (compensation for risk). Investors are generally risk-adverse, and demand a premium for bearing risk. The grater the risk of an investment opportunity, the grater the risk premium required by investors therefore, the required rate of return of a division or a project depends on its risk. Since investors are risk adverse, divisions and projects with differing risks should be evaluated using their risk adjusted rates of return.

The firm’s risk is composed of its overall operating risk and financial risk. Operating risk arises due to the uncertainty of cash flows of the firm’s investments. Financial risk arises is also a composite risk of assets financed by the firm. Thus, the firm’s cost of capital reflects the rate of return required on its securities commensurate with the perceived average risk. The firm’s cost of capital therefore cannot be used for evaluating individual divisions or investment projects that have different degree of risk. The firm’s cost of capital as a required rate of return for all projects may work well in case of companies that have single line of business or where different businesses are highly correlated. In highly diversified, multiple business firms, all projects cannot have same risk. Even a business, which basically operates in fast moving consumer products markets, has distinct markets for its consumer products. In each, market segment, business is exposed to different degree of competition and other environmental forces, which results in different risks for all its market segments. Hence, it is essential to estimate the required rate of return for each market segment or division than using the firm’s cost of capital as a single, corporate-wide required rate of return for evaluating project of divisions rather, projects within a single division may differ in risk. For example, the risk of introducing a new, innovative project will be higher than the expansion of an existing project. Hence, there is need for calculating the required rate of return for projects within a division.

The capital asset pricing model (CAPM) is healthful in determining the required rate of return (or the cost of capital) for a division or a project. The risk free rate and the market premium for divisions or projects are same as for the firm. What we need the divisional or project betas. In practice, it is difficult to estimate divisional or project betas.

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