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Improve the Economics of your Capital Project by Finding its True Cost of Capital

Author

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  • Schmal, Tom

Abstract

Evaluating the risk behind capital projects can be one of management’s toughest calls. One reason is project risks are presented subjectively or as a metric without a practical relationship to return. The author addresses the problem by using a Monte Carlo simulation to find a project’s risk and uses that metric to find the project’s 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 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. "Improve the Economics of your Capital Project by Finding its True Cost of Capital," MPRA Paper 68092, University Library of Munich, Germany.
    • Handle: RePEc:pra:mprapa:68092
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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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