The Cost of Capital for Projects
The procedure described for calculating the cost of capital for divisions can be followed in the case of large projects. Many times it may be quite difficult to identify comparable firms. You can estimate a project’s beta based on its operating leverage. You may also consider the variability of the project’s earnings to estimate the beta.
A simple practical approach to incorporate risk differences in projects is to adjust the firm’s or division’s WACC to evaluate the investment project:
Adjusted WACC = WACC +/- R
That is, a project’s cost of capital is equal to the firm’s or division’s weighted average cost of capital (WACC) plus or minus a risk adjustment factor, R. The risk adjustment factor would be determined on the basis of the decision maker’s past experience and judgment regarding the project’s risk. It should be noted that adjusting or division’s WACC for risk differences is not theoretically a very sound method; however, this approach is better than simply using the firm’s or division’s WACC for all projects without regard for their risk.
Companies in practice may develop policy guidelines for incorporating the project risk differences. One approach is to divide projects into broad risk classes, and use different discount rates based on the decision maker’s experience.
For example projects may be classified as:
- Low risk projects
- Medium risk projects
- High risk projects
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