Assessing Project Risk


  • Antonio E. Bernardo,

    1. ANTONIO BERNARDO is a Professor of Finance at the UCLA Anderson School of Management where he has also served as department chair and senior associate dean for academic affairs. Professor Bernardo received his Ph.D. in economics in 1994 from Stanford University and his B.A. in economics from the University of Western Ontario in 1989.
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  • Bhagwan Chowdhry,

    1. BHAGWAN CHOWDHRY is a Professor of Finance, and Faculty Director, Master of Financial Engineering program, at UCLA. He received his Ph.D. in 1989 from the Graduate School of Business at the University of Chicago. He also has an M.B.A. in Finance from the University of Iowa and a B. Tech. in Mechanical Engineering from Indian Institute of Technology.
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  • Amit Goyal

    1. AMIT GOYAL is Swiss Finance Institute Professor of Finance at University of Lausanne, Switzerland. Formerly on the faculty of Emory University Prof. Goyal holds a Ph.D. in finance from UCLA, an M.B.A. from the Indian Institute of Management and a B. Tech. in Computer Science from Indian Institute of Technology.
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Finding the appropriate discount rate, or cost of capital, for evaluating investment projects requires an accurate estimate of project risk. This can be challenging because project risk cannot be estimated directly using the CAPM, but must instead be inferred from a set of traded securities, typically the equity betas of comparable firms in the same industry. These equity betas are then unlevered to undo the effect of comparable companies' financial leverage and obtain estimates of “asset” betas, which are then used to estimate project risk.

The authors show that asset betas estimated in this way are likely to overestimate project risk. The equity returns of companies are risky not only because of their existing projects but also because of their growth opportunities. Such growth opportunities often include embedded “real options,” such as the option to delay, expand, or abandon a project. Because such real options are similar to leveraged positions in the underlying project, a company's growth opportunities are typically riskier than its existing projects. Therefore, to properly assess project risk, analysts must also unlever the asset betas derived from comparable company stock returns for the leverage contributed by their growth options.

The authors derive a simple method for unlevering asset betas for growth options leverage in order to properly assess project risk. They then show that standard methods for assessing project risk significantly overestimate project costs of capital—by as much as 2–3% in industries such as healthcare, pharmaceuticals, communications, medical equipment, and entertainment. Their method should also be applied to stock return volatility to derive project volatility, an important input for determining the value of a firm's growth opportunities and the appropriate time for investing in these opportunities.