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How to determine the Cost of Capital of a project?
The method that is used to calculate the cost of capital for divisions can also be used to determine the cost of capital of projects. It’s hard to find comparable projects that resemble each other in all aspects. The risk profiles of companies depend on their operating leverage. This should be remembered while determining the beta of a project. The variability of a project’s earning can also be used to determine the beta.
A simple way to incorporate risk differences into similar projects is to add or subtract the risk associated with the project. So, the weighted average cost of capital plus or minus the risk associated gives the adjusted WACC value for determining the value of a project.
𝐀𝐝𝐣𝐮𝐬𝐭𝐞𝐝 𝐖𝐀𝐂𝐂 = 𝐖𝐀𝐂𝐂 ± 𝐀𝐬𝐬𝐨𝐜𝐢𝐚𝐭𝐞𝐝 𝐑𝐢𝐬𝐤
Therefore, a project’s cost of capital is equal to the weighted average cost of capital of a project plus or minus the risk factor, R, of the project. The value of "R" is not a given factor and it should be determined by the evaluator using his knowledge and experience.
Notably, adjusting WACC for the determination of the cost of capital of a project is not a very theoretically sound method. However, it is more accurate to use rather than using just the WACC for comparing and projecting the cost of capital of projects.
In practice, companies may develop policy guidelines for including the projects’ risk differences. The projects may be classified into three types depending on their risk profiles, which are −
Low-risk projects − Low-risk projects usually include modernization and replacement projects. The analysts can determine the benefits that include reduction in costs and increase in revenues by his or her own judgment accurately in low-risk projects.
Medium-risk projects − Medium risk projects include projects for expansion of business and growth of the current business. The calculation of revenue and costs is difficult to make, but business owners can make these estimates relatively easily in the case of investment projects. Medium risk businesses require the idea of future cash flows and business owners, and managers can use their own judgment to determine the future cash flows nearly accurately.
High-risk projects − High-risk projects include diversification into new businesses. As the owner or manager has little idea about the future cash flows, he or she is in greater danger of calculating the cash flows in the future. Therefore, determining the cost of capital for high-risk projects is cumbersome and critical.
As is obvious, determining the future cash flows and beta is important for evaluating the worth and profitability of a project. Although there are hardships in determining the cost of capital of projects, businesses can determine the cost of capital more or less accurately by using one’s own judgment and knowledge.
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