The company cost of capital is defined as the expected return on a

portfolio of all the companys existing securities. It is the opportunity cost

of capital for investments in the firms assets and therefore the
appropriate discount rate. If the firm has no outstanding debt, then the
expected cost of capital is the required rate of return on the firms stock.
However, if a company thinks a new project to take on and the project
does not exactly mirror the existing risk of the business, then the company
cost of capital is not the appropriate discount rate. Each project must
essentially be evaluated at its own opportunity cost of capital, which is
the return investors could expect in the capital market when investing in
an asset of similar risk.
Thus the cost of capital is estimated as a blend of the cost of debt and the
cost of equity. In the real world, the correct discount rate also includes the
deduction of tax shields and is estimated as a weighted-average cost of
capital. While figuring out the cost of debt is usually easy, the hardest part
is estimating cost of equity. Therefore, companies often turn to CAPM and
try to identify the projects equity Beta and then derive to the WACC. The
problem is that you cannot find Betas by checking a few day-to-day stock
prices in the newspaper. But we can get useful information through
statistical estimates from the history of stock & market returns and linear
regressions. On tip of financial managers is to turn to industry betas rather
than individual company betas, as these are more reliable and often
estimated more precisely. For individual stocks, market observations often
include much individual noise which make it hard to find true values.
Theses individual factors are somewhat canceled out when using industry
estimates.
Furthermore, if a company wants to launch a project in a particular line of
business, to estimate the appropriate cost of capital it is advised to look at
pure plays in that line of business (companies which specialize purely in
this activity) (Side note: company overarching cost of capitals are useless
for conglomerates). When good comparables are not available a financial
manager needs to do the following:
1. Think about the determinants of the asset betas, often the
characteristics of overall high and low betas can be observed when the
beta itself cannot be.
Cyclical Firms: Many people associate risk with the variability of
earnings or cash flow, however what really counts is the strength of
the relationship between the firms earnings and the aggregate
earnings on all asset betas (measured either as earnings beta or
cash-flow beta). Cyclical firms whose revenues are dependent of the
state of the business cycle tend to be high-beta firms, as their
performance is strongly tied to the economy.
Operating Leverage: A facility with high fixed costs relative to
variable costs is said to have high operating leverage, which in tern
indicates a high asset beta.
Others: A project with very long-term cash flows is more exposed to
shifts in the discount and risk free rate than one with short-term
cash flows higher beta.
2. Dont be fooled by diversifiable risk

People often of risk as things that can go wrong (e.g. a geologist

looking for oil might fear finding a dry hole), however these risks are
often diversifiable. Often financial managers increase discount rates
in an attempt to offset these risks, however this makes no sence as
diversifiable risk should not increase the cost of capital.
3. Avoid fudge factors. Do not include fudge factors into the discount rate.
Adju st cashflows first.
The necessity to adapt a projects PV often comes from managers
thinking through possible cashflows. If this is the case, do not insert
these factors into discount rates to derive at the right PV, but rather
adapt the cash flows.
Determinants of Asset betas