Divisional and scheme Cost of Capital

Asset - Divisional and scheme Cost of Capital

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We emphasize that the required rate of return, or the cost of capital is a store thought about rate and it reflects payment to investors for the time value of money and risk of the investment project. It is, thus, composed of a risk free rate (compensation for time) plus a risk superior rate (compensation for risk). Investors are generally risk-adverse, and inquire a superior for bearing risk. The grater the risk of an investment opportunity, the grater the risk superior required by investors therefore, the required rate of return of a agency or a project depends on its risk. Since investors are risk adverse, divisions and projects with differing risks should be evaluated using their risk adjusted rates of return.

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Asset

The firms risk is composed of its overall operating risk and financial risk. Operating risk arises due to the uncertainty of cash flows of the firms investments. Financial risk arises is also a composite risk of assets financed by the firm. Thus, the firms cost of capital reflects the rate of return required on its securities commensurate with the perceived median risk. The firms cost of capital therefore cannot be used for evaluating personel divisions or investment projects that have distinct degree of risk. The firms cost of capital as a required rate of return for all projects may work well in case of clubs that have single line of company or where distinct businesses are highly correlated. In highly diversified, multiple company firms, all projects cannot have same risk. Even a business, which basically operates in fast provocative consumer products markets, has determined markets for its consumer products. In each, store segment, company is exposed to distinct degree of competition and other environmental forces, which results in distinct risks for all its store segments. Hence, it is indispensable to evaluation the required rate of return for each store segment or agency than using the firms cost of capital as a single, corporate-wide required rate of return for evaluating project of divisions rather, and projects within a single agency may differ in risk. For example, the risk of introducing a new, innovative project will be higher than the expansion of an existing project. Hence, there is need for calculating the required rate of return for projects within a division.

The capital asset pricing model is restorative in determining the required rate of return (or the cost of capital) for a agency or a project. The risk free rate and the store superior for divisions or projects are same as for the firm. What we need the divisional or project betas. In practice, it is difficult to evaluation divisional or project betas.

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