Suppose a newly hired manager uses her company's cost of capital to evaluate all projects. Will she underestimate or overestimate the value of high-risk project

Question

Suppose a newly hired manager uses her company's cost of capital to evaluate all projects. Will she underestimate or overestimate the value of high-risk projects? Explain.

Answer 1

Hi Ariel,

 

She will overestimate the value of a high-risk project.  The cost of capital rises with risk.  Bonds, for example, which are very safe, come with small cost.  Stocks come with higher cost, because investors demand a higher expected return to compensate for the increased risk.

 

Essentially, if the investors knew that the newly hired manager was going to blow their investment on a series of risky projects, they would demand a higher expected return to compensate them for the risk.

 

I hope that helps.

 

Regards,

Mike N.