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For the Pure-Play Firm: Find the True Cost of Capital for Your Capital Projects

Schmal, Tom (2015): For the Pure-Play Firm: Find the True Cost of Capital for Your Capital Projects.

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Abstract

Approving capital projects can be one of management’s toughest calls. One reason is while a project's return can be presented quantitatively, eg., IRR, its risks have no comparable metric. The author addresses the problem by showing how to use a Monte Carlo simulation to measure your project’s risk and how to use that risk to find its true, risk-adjusted, cost of capital. In this system, risk is determined by variation in free cash flow. Since every project in your company’s pipeline will have a forecasted free cash flow, every project, including those with financial leverage, can be evaluated using the same economic yardstick. Other benefits include better value projects, better presentation and accurate discount rates for NPV.

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