In order to determine reasonable costs of capital for average,
high and low risk projects the firm should develop risk-adjusted
costs of capital for each category of risk based on the concept of
divisional WACC. If a firm estimates that its cost of capital for
the coming year will be 10%, the firm should use 10% as the basis
for its average risk projects since the firm will need to achieve a
minimum of a 10% return on all its projects. Typically, a high-risk
project has the potential for higher returns and a low-risk project
will typically yield lower returns. Therefore, the firm could set
the cost of capital for its high-risk projects at 12% and the cost
of capital for low risk projects at 8%. Since the average risk
project has a 10% cost of capital, the overall risk of the firms
projects will be equal to the 10% cost of capital. Similarly, if
the firm's high-risk projects are particularly risky, they could be
set at a 15% cost of capital and the low-risk projects will be
adjusted down to a 5% cost of capital. The ultimate goal is that
the portfolio of the firm's projects will achieve the required 10%
return or greater so that the cost of capital to fund the projects
is covered. The assignment of risk is somewhat subjective but it is
better than not adjusting the risk at all.
