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9-3 Analyzing Project Risk ​

A company that wants to set a cost of capital for one particular line of business typically looks for pure plays in that line of business. Overall company costs of capital are almost useless for conglomerates. Conglomerates diversify into several unrelated industries, so they have to consider industry-specific costs of capital.

Pure plays vs Conglomarets

Pure-play companies are public firms that specialize in one activity.

Conglomarates are public firms that aren't specialized in one activity and thus operate in different industries under one corporate group.

The trick is picking comparables with business risks that are most similar to the companies. Sometimes good comparables are not available or not a good match to a particular project. Then the financial manager has to exercise his or her judgment. Here we offer the following advice:

  • Think about the determinants of asset betas. Often the characteristics of high- and low- beta assets can be observed when the beta itself cannot be.
  • Don’t be fooled by diversifiable risk
  • Avoid fudge factors. Don’t give in to the temptation to add fudge factors to the discount rate to offset things that could go wrong with the proposed investment. Adjust cash-flow forecasts first.

Let's take a look at the above three points in more detail now.

What Determines Asset Betas? ​

  • Cyclicality: Many people’s intuition associates risk with the variability of earnings or cash flow. But much of this variability reflects diversifiable risk. What really counts is the strength of the relationship between the firm’s earnings and the aggregate earnings on real assets. This can be measured either by the earnings beta or by the cash flow beta. These are just like a real beta except that changes in earnings or cash flow are used in place of rates of return on securities. We would predict that firms with high earnings or cash-flow betas should also have high asset betas. This means that cyclical firms – firms whose revenues and earnings are strongly dependent on the state of the business cycle – tend to be high-beta firms. Thus you can demand a higher rate of return from investments whose performance is strongly tied tothe performance of the economy. Examples of cyclical businesses: airlines, luxury resorts, construction, and steel.

  • Operating Leverage: A production facility with high fixed costs, relative to variable costs, is said to have high operating leverage. High operating leverage means a high asset beta. Given the cyclicality of revenues (reflected in $$\beta_{\text {revenue }}$$), the asset beta is proportional to the ratio of the present value of fixed costs to the present value of the project. (see example on page 222/223)

  • Other Sources of Risk: Cash-flow risk is not the only risk. A project’s value is equal to the expected cash flow discounted at the risk-adjusted discount factor. If either the risk-free rate or the market risk premium changes, then r will change and so will the project value. A project with very long-term cash flows is more exposed to such shifts in the discount rate than one with short-term cash flows. This project will, therefore, have a high beta even though it may not have high operating leverage and cyclicality.

Don’t be fooled by Diversifiable Risk ​

We have defined risk as the asset beta for a firm, industry, or project. But in everyday usage, “risk” simply means “bad outcome”. People think of the risks of a project as a list of everything that can go wrong. However, these risks are all diversifiable thus the hazards do not affect the asset betas and should not affect the discount rate for the projects. Diversifiable risks should not increase the cost of capital.

Avoid fudge factors ​

Don’t give in to the temptation to add fudge factors to the discount rate to offset things that could go wrong with the proposed investment. Adjust cash-flow forecasts first.