How Risky is your Project Really? Corporate Finance Strategies for Assessing Risk

Abstract

Risk is a vital concept to grasp when investing in a firm or project. It is a key ingredient required to evaluate the cost of capital and perform a valuation. The capital structure used to finance a firm or project and specifically the amount of leverage and debt financing employed must be accounted for to correctly assess a project’s risk and perform an accurate valuation. There are different measures of risk available to us to assess the risk. In this paper we review common risk measures used by practitioners and give an overview of the CAPM beta which measures a firm’s systematic risk and assumes that investors are not rewarded for firm specific risk (Berk and DeMarzo, 2016). We review the CAPM model commonly used in corporate finance and show how to calculate beta. Furthermore we discuss how risk increases with leverage and the level of debt financing used to finance a company or project, which consequently increases expected returns (Brealey et al, 2014). We discuss how CAPM beta can be calculated as the co-movement of returns with the market and/or equivalently as the slope of a regression analysis. For firms and projects that are illiquid and/or have no public data we can imply beta risk from comparable company data, however we are required to unlever and relever beta’s to remove leverage effects from the comparables and introduce the leverage effects of the target to give a reliable indicator of beta risk (Koller et al, 2015). Not only is CAPM beta useful to assess the risk of a firm or project, but it is essential to calculate the weighted average cost of capital (WACC). This is the expected return investors require to invest in a project and incorporate the correct level of risk. Consequently CAPM beta risk is a key ingredient required to value of a firm or project and perform a discounted cash flows (DCF) analysis, see (Burgess 2020a), (Burgess 2020b) and (Burgess 2020c).