Summary  53
Summary
This chapter has explored how expected cash flows, discounted at a cost of 
capital, drive value. Cash flow, in turn, is driven by expected returns on in-
vested capital and revenue growth. Companies create value only when ROIC 
exceeds their cost of capital. Further, higher-ROIC companies should typically 
prioritize growth over further improving ROIC, as growth is a more powerful 
value driver for them. In contrast, lower-ROIC companies should prioritize 
improving ROIC, as it is a stronger value driver for them.
A corollary of this is the conservation of value: anything that doesn’t 
increase cash flows doesn’t create value. So changing the appearance of a 
company’s performance through, say, accounting changes or write-ups or 
write-downs, without changing cash flows, won’t change a company’s value. 
Risk enters into valuation both through the company’s cost of capital and 
in the uncertainty of future cash flows. Because investors can diversify their 
portfolios, the only risk that affects the cost of capital is the risk that investors 
cannot diversify, a topic we take up in Chapters 4 and 15.

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4
Risk and the Cost 
of Capital
In valuing companies or projects, the subjects of risk and the cost of capital are 
essential, inseparable, and fraught with misconceptions. These misconceptions 
can lead to damaging strategic mistakes. For example, when a company borrows 
money to finance an acquisition and applies only the cost of debt to the target’s 
cash flows, it might easily overestimate by two times the target’s value. Conversely, 
when a company adds an arbitrary risk premium to a target’s cost of capital in an 
emerging market, it could underestimate the value of the target by half.
A company’s cost of capital is critical for determining value creation and 
for evaluating strategic decisions. It is the rate at which you discount future 
cash flows for a company or project. It is also the rate you compare with the 
return on invested capital to determine if the company is creating value. The 
cost of capital incorporates both the time value of money and the risk of in-
vestment in a company, business unit, or project.
In this chapter, we’ll explain why the cost of capital is not a cash cost, but an 
opportunity cost. The opportunity cost is based on what investors could earn 
by investing their money elsewhere at the same level of risk. This is always an 
option for publicly listed companies.1 Only certain types of risks—those that 
cannot be diversified—affect a company’s cost of capital. Other risks, which 
can be diversified, should only be reflected in the cash flow forecast using 
multiple cash flow scenarios.
We’ll also discuss how much cash flow risk to take on. Companies should 
take on all investments that have a positive expected value,2 regardless of 
1 As a reminder from Chapter 2, the amount of value that companies create is the amount they earn 
above their cost of capital. That is, companies create value only when they can invest funds at higher 
returns than their investors can earn themselves.
2 This is often referred to as net present value (NPV); we prefer the term expected value because it 
emphasizes the riskiness of underlying cash flows.