Financial Risk and Reward

Junior (College 3rd year) ・Business ・MLA

Suppose I can interview the presenters on the videos and, I would ask them only one question about financial risks and rewards. My question would be; would a company underestimate or overestimate the value of high-risk projects if it were to use its cost of capital to evaluate all its potential projects? 

The question is important because a company needs to identify the level of risks that a project might have relative to the normal business operations before drawing a budget for a new project. High-risk projects require a good percentage of the discount rate compared to the weighted average cost of capital of the company while low-risk projects require a small portion. Hence, the company is forced to undertake projects that would give more returns to compensate for the risks.

A company uses payback period, internal rate of return and net present value to evaluate the most profitable project. It implies that a project is effective if its expected profits exceed the cost of financing it. Overestimating capital costs may expose a company to loss since overestimation gives a project a high net present value. Having an idea of the company’s weighted average cost of capital would assist in identifying sources of capital including bonds and stock issues.

A company should estimate the cost of its debt and equity based on the new issuance because borrowing cost varies over time. Depending on the current average may lead to incorrect calculations on the cost of capital hence it may cause over or underestimation the value of high-risk projects. A company should understand its history of the weighted average cost of capital so that it can easily finance its projects based on their risk incentives and profitability.

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