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Risk adjusted cost of capital: just like decorating a new home
Sunil Bhandari has a colourful way to helping you understand risk adjusted cost of capital
Risk adjusted cost of capital is a topic that students attempting CIMA F3 or ACCA F9 and P4 need to be able to cope with. In all three papers, this syllabus area is tested in a variety of ways and at different depths. However, experience has shown me that many students try to rote-learn the method without trying to understand the concepts behind the process.
I want to help you understand the basic ideas behind the calculations, but as is my norm I like to consider complicated problems and apply a simple thought process and use easy to understand illustrations.
Let me begin. Along with my wife Rita, I own a property. When we moved in my wife insisted (yes, insisted) the house needed to be decorated in a colour scheme of her choice. So, take the house, prior to being decorated, to be the same as a company asset beta. Then the board of directors (BoD) – my wife – has chosen the level of gearing (decoration) that is suitable. The decoration is like gearing up the house. Hence the house after it is decorated is equivalent of a company equity beta.
Now I have been saving money to buy an apartment in Manchester. As you may have read in an earlier edition of PQ, I have a particular reason to want to be in Manchester on a regular basis. An apartment is not the same as a house and it is in a different city to where my house is located. You could say this is equivalent to having different business risks. In addition, the apartment has been decorated to the tastes of the previous owners. In effect, it incorporates their gearing. This is then a proxy equity beta.
As you would expect, my good wife sends me to Manchester to remove all the decoration of the apartment (degear the proxy equity beta) and get the apartment back to its bricks and mortar condition – project asset beta.
I am then authorised to redecorate the place in the same colour scheme as our home. I have regeared the project asset beta into a project equity beta. The apartment is totally different in shape and size when compared with my house, but is decorated in the same colour scheme as my house. Hence the company equity beta does NOT EQUAL the project equity beta, but the level of gearing in both are the same.
In the exam room we go onto to use the CAPM equation to find the Risk Adjusted Ke. This is the stopping point for an ACCA F9 question. However, in CIMA F3 and ACCA P4 we go two steps further to find the Risk Adjusted WACC.
I hope now when you come across this topic in your studies you will find it less daunting. For me, please let me return to my decorating!
• Sunil Bhandari is freelance tutor and writer and Manchester United supporter
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