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For the Pure-Play Firm: Find the True Cost of Capital for Your Capital Projects

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  • Schmal, Tom

Abstract

Approving capital projects can be one of management’s toughest calls. One reason is while a project's return can be presented quantitatively, eg., IRR, its risks have no comparable metric. The author addresses the problem by showing how to use a Monte Carlo simulation to measure your project’s risk and how to use that risk to find its true, risk-adjusted, cost of capital. In this system, risk is determined by variation in free cash flow. Since every project in your company’s pipeline will have a forecasted free cash flow, every project, including those with financial leverage, can be evaluated using the same economic yardstick. Other benefits include better value projects, better presentation and accurate discount rates for NPV.

Suggested Citation

  • Schmal, Tom, 2015. "For the Pure-Play Firm: Find the True Cost of Capital for Your Capital Projects," MPRA Paper 71100, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:71100
    as

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    References listed on IDEAS

    as
    1. J. Tobin, 1958. "Liquidity Preference as Behavior Towards Risk," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 25(2), pages 65-86.
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    More about this item

    Keywords

    cost of capital; IRR; NPV; cash flow; Monte Carlo; capital project economics; risk-adjusted return; M-P5; variability; pure play; leverage; hurdle rate.;
    All these keywords.

    JEL classification:

    • D81 - Microeconomics - - Information, Knowledge, and Uncertainty - - - Criteria for Decision-Making under Risk and Uncertainty
    • G32 - Financial Economics - - Corporate Finance and Governance - - - Financing Policy; Financial Risk and Risk Management; Capital and Ownership Structure; Value of Firms; Goodwill

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