Factors Influencing Systemic Risk of a Project and How It May Differ from an Organization’s Systemic Risk
When a specific project differs from the core operations of an organization, using the organization’s Weighted Average Cost of Capital (WACC) for evaluation can be a mistake. The beta of an organization’s assets may differ from the beta of the project, indicating that the risk could be higher or lower.
Factors Affecting Project Asset Beta
The beta of a project’s assets is influenced by three main factors: market cycles, operational leverage, and duration.
- Market Cycles
Compare the project’s revenue dependence on overall economic conditions with that of the organization. Is it more or less dependent? Sectors vary in their sensitivity to market conditions. For instance, construction and air transportation revenues are more market-dependent than tobacco and food. A common error is conflating specific risks with cyclicality. For example, pharmaceutical companies spend heavily on research, sometimes achieving breakthroughs and sometimes not, leading to high variability in outcomes and high specific risk. However, this risk is unrelated to overall market fluctuations, making it a mistake to include such risk in the discount rate (since the risk is diversifiable). - Operational Leverage
This depends on the ratio of variable to fixed costs. The higher the proportion of fixed costs, the riskier the project, and thus the more sensitive the project’s asset beta is to market volatility. The formula is: [
\text{Asset } \beta = \text{Revenue } \beta \times \left[1 + \frac{\text{PV (Fixed Costs)}}{\text{PV (Assets)}}\right]
] Smart investors discount fixed and variable costs at different rates. Consider two projects with identical revenues, costs, and expected profits but different cost structures. Which project would be more attractive for investment? Imagine you are participating in two construction tenders: in one, you bear the risk of material prices, while in the other, the client bears this risk. Which project would be more attractive under otherwise equal conditions? Therefore, when evaluating a new project, compare its cost structure with the organization’s average cost structure. - Duration
The project’s duration is not inherently a risk but affects risks such as interest rate volatility and inflation (which impacts the real interest rate). These risks are higher in long-term projects compared to short-term ones.
Understanding these factors helps investors accurately assess the specific risks of a project compared to the broader organizational risks, leading to more informed and strategic investment decisions.
Source:
Principles of Corporate Finance, by Richard Brealey, Stewart Myers, and Franklin Allen