Your boss has asked you to evaluate an investment your company may make to expand manufacturing capabilities and potentially capture additional market share. However, expansion is expensive, and it will take time and funds from other projects the company could pursue.
Recommending projects to invest in is a critical strategic decision. On paper, this choice is easy: pursue the projects whose revenues exceed the costs. Yet in practice, estimating revenues and costs of investment projects presents significant challenges because of an unobservable key cost: the cost of the equity capital invested in the project.
If your company is like most, you use a standard cost of equity capital for all investments—for example, 10%. But how much confidence should you have in a universal number? Does it make sense to apply the same cost of equity capital to all investment projects?
Since the cost of equity capital is an essential input for investment decisions, you should use a model that better captures the appropriate cost than a universally applied percentage can. The capital asset pricing model (CAPM) uses multiple steps that each requires careful consideration of factors specific to your company and investment project.
Although the CAPM is the most widely used method in practice to estimate the cost of equity capital, it has a number of drawbacks. When applying the CAPM, you must recognize its main limitations and understand how to handle them to base your investment decision on the best possible estimate.
How would you begin to uncover the hidden cost of a project to make the best recommendation to your boss? The Accenture Academy course Introduction to the Cost of Equity Capital examines the principles of estimating the cost of equity capital and demonstrates how to apply the CAPM method to help you assess the value-add of investment projects for your company.