Chapter 18 - clarification requested

Just reading through Chapter 18 (page 6), I encountered the textbook stating that:

The beta measure relates to the company's (or industry's) existing activities. We need to consider whether the risk associated with any proposed project is consistent with the company's existing risk profile. This is because the appropriate cost of capital to use in decision making is the rate of return offered by equivalent investment alternatives, i.e. with the same level of systematic risk.

This explanation doesn't sit well with me because it seems that discussion shifts rather abruptly from the company's beta to cost of capital without much in between.

To rephrase the above is it correct to say the following?

1. The appropriate cost of capital to use in decision making for a given project is the rate of return offered by equivalent(ly risky) investment alternatives - noting that investors care about both risk and return when investing.
2. Therefore by analogy, the company's beta (and therefore WACC) would be the appropriate measure to be used in decision making regarding a given project if the level of systematic risk associated with that project is similar to the systematic risk faced by the company in general.

Thanks for any clarification.

 

Beta can be understood as the change in company's stock with respect to the change in whole market return.
It also depends on the gearing of a company and therefore is different in different gearing patterns.

Cost of capital (generally WACC) is used to evaluate the project profitability.
It has a component of beta but it is very different from beta.

 

Thanks for that. My understanding which I've gleaned from the notes is that (and correct me if I'm wrong):

1. If a given project achieves a positive NPV at the company's optimal WACC, that project increases shareholder wealth.
2. The WACC is an appropriate discount rate to use if the project's systematic risk is similar to that of the company as a whole.
3. The beta of the project is a measure of its systematic risk.
4. The beta of the project is not the same as the beta of the company (noting that the beta of the company is a component of its cost of equity and its WACC).

What I would like to have a better understanding of is the connection between a company's WACC and the appropriate discount rate when the project's systematic risk is not comparable to the company's systematic risk.

In practical terms, if you know that the systematic risk of the project will be very different from the systematic risk faced by the company in general, doesn't the WACC become irrelevant? Why not, for instance, simply jump directly to assessing project beta and apply CAPM to figure out the discount rate?

 

The discount rate that will be used when the project has more systematic risk than the company as a whole will be higher than the WACC, to reflect higher risk.

The WACC of the company is not required in such a case.
However a calculation of the WACC for the project considering it's capital structure will be suitable to determine the required rate of return.

The drawback for all the riskier projects is that distant cashflows get a very little weightage because of the higher discount rate.

 

Thanks Colin, appreciate it!