Suppose a firm estimates its cost of capital for the coming year to be 10 percent?

Question

What are reasonable costs of capital for evaluating average-risk projects, high-risk projects, and low-risk projects?

Answer 1

For high risk projects you choose low cost of capital, for medium risk medium cost of capital and and low risk normaly available cost of capital. For high risk projects you finance with equity and for low risk with debt. That is why monopolies can leverage to the hilt since they are low risk and it is regulated theoretically.

Answer 2

Hello

When you are evaluating a project, your are deciding how to invest your money. One option that is always available to you is investing in bonds.

Different bonds hold different risks, this is reflected in the intrest rates that these bonds give as a return on your investment.

When you are looking for a reasonable cost of capital for evaluating a project, you should at least use the intrest rates that are currently used for bonds. If you use a lower rate (i.e. if you expect a lower return on investment), it's better not to invest in a project and invest in bonds right away.

On this moment, bondrates for low-risk-bonds are around 3,5 to 4%. Medium-risk-bonds are around 4,5 tot 6%. High-risk-bonds are around 7 to 10%.

Remember, these are the absolute minima you should use as cost of capital. I think it is wise to add around 4% to get a realistic cost of capital. I would use:

8% for a low-risk project;
11% for a medium-risk project;
14% for a high-risk project.

I hope you will find this answer usefull.

Good luck.

Answer 3

With any project you need to add in a premium for the risk, even the low risk projects. This is due to inflation and other factors. For example, for the high risk project, you might add in a 5% premium for that project because it might not work. So, if during your analysis of what windfall the project might bring, you calculate a 14% return, you reject the project because the risk does not equal the reward. It all comes down to risk and reward.