The formula of calculating the cost of debt is: Cost of debt = rd(1-T) The cost of debt (rd), is the interest rate payable to the lender. This interest rate is adjusted by the tax rate (T) since tax expense is an allowable deduction for taxation purposes. It is described as the after-tax component of debt (Brigham et al 2005). The cost of equity is based on the return on shareholders investment in the business. This return depends on how the business is financed. The formula for calculating cost of equity using the capital asset pricing model (CAPM) approach is: re = rRF + (RPM)b The cost of equity (re) is the cost to the company of using equity, whether in the form of retained earnings or issuing new shares to fund projects.
The risk free rate (rRF), is the risk free rate of interest and is usually the treasury bill rate (Brigham et al 2005). The risk premium (RPM), represents the difference between the expected market return and the risk free rate. The index of the riskiness of the company is represented by its beta, b.
2.1 Risk Management Strategies It is assumed that managers will take on those projects that have positive cash flows and reject those that do not (Heaton 2002). However, risks are still involved in every project and so cash flows may not occur as planned. Therefore, the manager may consider using risk retention, risk transfer, risk control and risk avoidance strategies to counter the effects of uncertainties. Additionally, changes in the discount rate due to inflation can affect k. A risk matrix illustrating the probabilities and consequences of these strategies is provided the Appendix.
2.1.1 Risk retention Risk retention is dependent on the level of risk inherent in a project. If a higher proportion of equity than debt is used then the company retains the risk for the project. Risk retention is evaluated by an assessment of the probability of the project being high, medium or low risk. If the risk is low then the project can be funded from internal sources thus retaining the risk (Kallman n. d.). The variability of Ct is normally taken into consideration as this can have a negative impact on NPV.
In fact, it can change a project with a positive NPV into one with a negative NPV and that is why an assessment of the risks attached to the components, the revenues and expenses associated with the project. If the variability of Ct is minimal and the level of uncertainty is low then risk retention is favoured. However, if there is high variability in cash flows and the level of uncertainty is high then risk retention should not be considered.
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