Respuesta :
The reasonable costs of capital for average-risk, high-risk, and low-risk projects could be found by generating risk-adjusted costs of capital for each category of risk based on the idea of divisional WACC.
What is Weighted Average Cost of Capital (WACC)?
The Weighted Average Cost of Capital (WACC) of a company is a measure of its total capital cost, which includes debt, common shares, and preferred shares.
Estimation of the reasonable costs of capital or average-risk, high-risk, and low-risk projects could be done in following way-
- If a company anticipates that its cost of capital for the upcoming year will be 10%, it should use 10% as the basis for its average risk projects because it will be required to generate returns of at least 10% on each of those projects.
- A high-risk project often has a higher potential return, while a low-risk project typically has a lower potential return.
- As a result, the company might decide to set its capital costs for high-risk initiatives at 12 percent and for low-risk ones at 8 percent.
- The entire risk of the firm's projects will be equal to the 10 percent cost of capital because the average risk project has a 10 percent cost of capital.
- Similar to this, the company's high-risk initiatives may be placed at a 15 percent cost of capital while the low-risk projects are reduced to a 5 percent cost of capital, depending on how hazardous they are.
- The ultimate objective is for the firm's portfolio of projects to generate a return of at least 10%, covering the cost of capital used to fund the projects.
- Although the risk assignment is somewhat arbitrary, it is still preferable to making no adjustments at all.
To know more about the weighted average cost of capital and it's purpose, here
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