For the Pure-Play Firm: Find the True Cost of Capital
for Your Capital Projects
By Tom Schmal Research Papers in Economics (RePEc), November 23, 2015
Abstract Approving capital projects can be one of management’s toughest calls. One reason is while a project's return can be presented quantitatively, eg., IRR, its risks have no comparable metric. The author addresses the problem by showing how to use a Monte Carlo simulation to measure your project’s risk and how to use that risk to find its true, risk-adjusted, cost of capital. In this system, risk is determined by variation in free cash flow. Since every project in your company’s pipeline will have a free cash flow, every project, including those with financial leverage, can be evaluated using the same economic yardstick. Benefits include higher value projects, better presentation and accurate discount rates for NPV.
Keywords: cost of capital, IRR, NPV, cash flow, Monte Carlo, capital project economics, risk-adjusted return, M-P5, variability, pure play, leverage, hurdle rate. JEL: D81, G32
1. Introduction This paper will show the reader how to build the chart in Figure 1. Something similar should accompany capital appropriations requests. It puts proposed projects in context with past projects and helps confirm their place in management’s overall strategy.
Figure 1. The M-P5 Chart.
Here “NewProject” has about a three percent premium above its risk-adjusted cost of capital (RACC). Horizontally, it is near in the middle of the pack.
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