BUS 313

What return does this risk deserve?

Name: Business Tutor
Address: Burnaby, BC, CA
Telephone: +1-604-916-5838
Price range: C$30–C$129

History shows risk has been paid for. The CAPM says only market risk counts. Measure it with beta, put it on the security market line, and read off the cost of capital.

Part 1 · Returns and the cost of capital · Step 1 of 10

A project must earn its cost of capital, or it destroys value

Part 1 · Returns and the cost of capital · Step 1 of 10

A project must earn its cost of capital, or it destroys value

Managers decide which projects get shareholders' money. A project is worth doing only if it earns at least what shareholders could earn elsewhere on an investment just as risky: the cost of capital. Bad choices can wipe out a lot of value, which is why share prices sometimes fall when a firm announces a big jump in spending. In the early 1980s, large oil companies used a short-lived windfall of cash to raise exploration spending just as the outlook for new oil turned poor, and their shareholders ended up with low or even negative returns.

Try it: Set the project's return below the cost of capital. The firm spends $100 million and gets back cash flows worth less.

Return the project earns each year6%

Cost of capital (what the same risk earns elsewhere)10%

NPV

−$40M

Value of the cash flows

$60M

Each $1 spent is worth

$0.60

The project makes a profit of $6M a year. But the same $100M could earn 10% a year elsewhere at the same risk, so its cash flows are worth only $60M. Doing it destroys $40M of shareholders' value.

Yearly cash flow C = $100M × 6% = $6M

The project earns its return on the $100M every year.

Value = $6M ÷ 0.1 = $60M

A level cash flow that lasts forever is worth C ÷ r today.

NPV = $60M − $100M = −$40M

Check yourself

A new plant will earn 7% a year. Investors could earn 9% elsewhere on investments just as risky. The plant…

Midterm coming up and beta and the SML still feel slippery?

Bring your problem sets. We work through them together until every type feels routine.

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What return does this risk deserve?

A project must earn its cost of capital, or it destroys value

A project must earn its cost of capital, or it destroys value

The security market line from two numbers

Midterm coming up and beta and the SML still feel slippery?

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