Create Better Forecasts, Not Ad Hoc Risk Premiums  59 by academics and practitioners, but so far, no practical competing model has emerged.6 At any rate, when returns on capital across companies vary from less than 5 percent to more than 30 percent (sometimes even within the same sector), a one-percentage-point difference in the cost of capital seems hardly worth arguing about. The unique risks that any company faces—say, product obsolescence and new competition—are not priced into the cost of capital. That does not mean a company’s value is immune to these risks; they do affect expected cash flows and therefore expected value. Companies certainly do need to worry about the effects of such risks, as we discuss later in this chapter. It is a common misconception that the cost of capital is company-spe- cific, rather than a function of the industries in which a company oper- ates and the specific investments it makes. For the most part, companies have scant influence over the cost of capital of their individual business units or their company as a whole. There are some theoretical examples of how companies could reduce their cost of capital. For example, a company could outsource production to lower fixed costs and therefore reduce the volatility of cash flows. If you can achieve lower volatility than your peers’, your cost of capital will be slightly lower. But it’s unlikely that the change in the cost of capital will be large enough relative to other strategic consid- erations of outsourcing manufacturing. Some companies have shortened the duration of their debt to try to reduce their cost of capital. What these companies fail to recognize is that this increases their risk because of the possibility that interest rates will be higher when the shorter-term debt is rolled over or that the company may have difficulty refinancing the debt at all. Create Better Forecasts, Not Ad Hoc Risk Premiums Certain projects carry what many investors see as high risk.7 These include large capital projects in politically unstable countries (common among com- panies in the mining and oil and gas sectors), speculative R&D projects in 6 Many in the academic community use the Fama-French three-factor model, but mostly for capital market research rather than business valuation. With this model, a stock’s excess returns are regressed on excess market returns (like the CAPM), the excess returns of small stocks minus big stocks (SMB), and the excess returns of high book-to-market stocks minus low book-to-market stocks (HML). In 2015, the authors expanded the model to five factors, adding operating profitability and investment. See E. Fama and K. French, “The Cross-Section of Expected Stock Returns,” Journal of Finance (June 1992): 427–465; E. Fama and K. French, “Common Risk Factors in the Returns on Stocks and Bonds,” Journal of Financial Economics 33 (1993): 3–56; and E. Fama and K. French, “A Five-Factor Asset Pricing Model,” Journal of Financial Economics 116 (2015): 1–22. 7 This section is adapted from R. Davies, M. Goedhart, and T. Koller, “Avoiding a Risk Premium That Unnecessarily Kills Your Project,” McKinsey on Finance, no. 44 (Summer 2012). 60  Risk and the Cost of Capital high tech and pharmaceuticals, and acquisitions of unproven technologies or businesses in a wide range of industries. The potential returns for such invest- ments are alluring, but what if the projects or companies fail? The answer is not to ignore these risks, but to explicitly include them in cash flow forecasts, not the cost of capital. The preferred way is to develop multiple cash flow scenarios. It’s not unusual for companies to bump up the assumed cost of capital to reflect the uncertainty of risky projects. In doing so, however, they often un- wittingly set these rates at levels that even substantial underlying risks would not justify—and end up rejecting good investment opportunities as a result.8 What many don’t realize is that assumptions of discount rates that are only three to five percentage points higher than the cost of capital can significantly reduce estimates of expected value. Adding just three percentage points to an 8 percent cost of capital for an acquisition, for example, can reduce its present value by 30 to 40 percent. Moreover, increasing the discount rate embeds into the valuation process opaque risk assumptions that are often based on little more than a gut sense that the risk is higher. The problem arises because companies take shortcuts when they estimate cash flows. To calculate expected value, project analysts should discount the expected cash flows at an appropriate cost of capital. In many cases, though, they use only estimates of cash flow that assume every- thing goes well. Managers, realizing this, increase the discount rate to com- pensate for the possibility that cash flows are overstated. A better approach for determining the expected value of a project is to develop multiple cash flow scenarios, value them at the unadjusted cost of capital, and then apply probabilities for the value of each scenario to estimate the expected value of the project or company. Exhibit 4.2 provides an exam- ple. For simplicity, we assume just two scenarios, one with a present value of $1,000 and the other with a present value of $1,667, based on each scenario’s expected cash flow. Assuming a 50 percent probability for each scenario leads to an expected value of $1,333. 8 M. Goedhart and P. Haden, “Are Emerging Markets as Risky as You Think?” McKinsey on Finance, no. 7 (Spring 2003). EXHIBIT 4.2  Scenario Approach to Incorporating Nondiversifiable Risk Expected net present value (NPV), $ Probability of scenario NPV at 8% WACC, $ Cash flows, $ Year 1 Year 2 Year 3 … 1,333 Base case: 50% 1,667 100 102 104 Downside case: 50% 1,000 60 61 62