Accounting for Risk in Shareholder Value Analysis

The cost of capital creates a benchmark for risk. Many firms use the cost of capital as a baseline and add a risk premium above the cost of capital to account for the risks discussed above. The cost of capital then becomes the minimum discount rate used for capital investments. The cost of capital would be used to discount more conservative investments such as real estate. More speculative projects such as implementation of state-of-the-art technology would command a discount rate of 50 percent or a return analogous to that of a venture capital fund.

Another method of accounting for risk is to use simulation techniques, which will be discussed in Chapter 11.