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

Risk is a vital concept to grasp when investing in a firm or project. It is also a key ingredient required to evaluate the cost of capital and perform a valuation. An organization’s capital structure, specifically the amount of leverage and debt financing employed, must be accounted for to correctly assess a project’s risk.

There are different measures of risk used by practitioners. The most widely used risk measure corporate finance is CAPM beta. It can be calculated as the co-movement of returns with the market and/or equivalently as the slope of a regression analysis. CAPM beta measures a firm’s exposure to systematic risk and assumes that investors are not rewarded for firm specific risk (Berk and DeMarzo, 2016).

Many firms and projects are illiquid and/or have no public data. In such cases we measure and imply beta risk from comparable company data. However risk increases with leverage and the level of debt financing used to finance the company or project (Brealey et al, 2014). Consequently, we are required to unlever and relever betas to remove leverage effects from the comparable company and add the leverage effects of the target company 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). It is the expected return investors require to invest in a project and incorporate the correct level of risk. The WACC is required to value of a firm or project and perform a discounted cash flows (DCF) analysis, see (Burgess 2020a), (Burgess 2020b) and (Burgess 2020c).