Valuation, 7th Edition

4Risk and the Cost of Capital

In valuing companies or projects, the subjects of risk and the cost of capital are essential, inseparable, and fraught with misconceptions. These misconceptions can lead to damaging strategic mistakes. For example, when a company borrows money to finance an acquisition and applies only the cost of debt to the target’s cash flows, it might easily overestimate by two times the target’s value. Conversely, when a company adds an arbitrary risk premium to a target’s cost of capital in an emerging market, it could underestimate the value of the target by half.

A company’s cost of capital is critical for determining value creation and for evaluating strategic decisions. It is the rate at which you discount future cash flows for a company or project. It is also the rate you compare with the return on invested capital to determine if the company is creating value. The cost of capital incorporates both the time value of money and the risk of investment in a company, business unit, or project.

In this chapter, we’ll explain why the cost of capital is not a cash cost, but an opportunity cost. The opportunity cost is based on what investors could earn by investing their money elsewhere at the same level of risk. This is always an option for publicly listed companies.¹ Only certain types of risks—those that cannot be diversified—affect a company’s cost of capital. Other risks, which can be diversified, should only be reflected in the cash flow forecast using ...