66  Risk and the Cost of Capital see that portfolios of projects had higher returns than most of the individual projects and much lower risk compared with most of the individual projects. It’s worth pointing out that even though a portfolio of projects has lower risk, the use of portfolios does not lower a company’s cost of capital. That’s because the portfolio, by definition, cannot reduce the nondiversifiable risk, which is the risk embedded in the cost of capital. Decide Which Types of Risk to Hedge There are also risks that investors are eager for companies to take. For ex- ample, investors in gold-mining companies and oil production companies buy those stocks to gain exposure to often-volatile gold or oil prices. If gold and oil companies attempt to hedge their revenues, that effort merely com- plicates life for their investors, who then must guess how much price risk is being hedged and how and whether management will change its policy in the future. Moreover, hedging may lock in today’s prices for two years, the time horizon within which it is possible to hedge those commodities, but a company’s present value includes the cash flows from subsequent years at fluctuating market prices. So while hedging may reduce the short-term cash flow volatility, it will have little effect on the company’s valuation based on long-term cash flows. Some risks, like the commodity price risk in this example, can be managed by shareholders themselves. Other, similar-looking risks—for example, some forms of currency risk—are harder for shareholders to manage. The general rule is to avoid hedging the first type of risk but hedge the second if possible. Consider the effect of U.S. dollar currency risk on Heineken, the global brewer. For the U.S. market, Heineken produces its flagship brand, Heineken, in the Netherlands, and ships it to America. In most other markets, it produces and sells in the same country. So, for most markets, an exchange rate change affects only the translation of local profits into their reporting currency. For example, for most markets, a 1 percent change in the value of the local cur- rency relative to the euro translates into a 1 percent change in revenues and a 1 percent change in profits as well. Note that the effect on revenues and profits is the same, because all the revenues and costs are in the same currency. There is no change in operating margin. The U.S. market is different. When the dollar/euro exchange rate changes, Heineken’s revenues in euros are affected, but its costs are not. If the dollar declines by 1 percent, Heineken’s euro revenues also decline by 1 percent. But since its costs are in euros, those don’t change. Assuming a 10 percent margin to begin with, a 1 percent decline in the dollar will reduce Heineken’s mar- gin to 9 percent, and its profits reported in euros will decline by a whopping 10 percent. Summary  67 Because Heineken’s production facilities are in a different country and it is unable to pass on cost increases because it is competing with locally produced products, its currency risk is larger for its U.S. business than for its other mar- kets. Hedging might be much more important for Heineken’s U.S. business than for other markets, because a rise or fall in the dollar/euro exchange rate has a much greater impact on its business. Summary To avoid unfavorable strategic decisions, executives must understand well the dynamic relationship between the cost of capital and risk. Risk enters valu- ation both through the company’s cost of capital (an opportunity cost) and through the uncertainty surrounding future cash flows. Because investors can diversify their portfolios, a company’s cost of capital is for the most part de- termined by the industry in which it operates. Valuations that use multiple cash flow scenarios better reflect diversifi- able risks than those that adjust the cost of capital. Executives tend to shy away from risky projects even if the potential return is high. This excessive loss aversion can be overcome by examining portfolios of projects, rather than individual ones.