Risk Management and the Cost of Capital for Operating Assets

This article attempts to clarify the effect of risk management on a company's cost of capital in the spirit of the traditional M&M/CAPM model. The traditional cost of capital model can and should be used to find the hurdle rate for a company's operating assets, since it can be applied regardless of the composition of the firm's non-operating assets or its risk management policy. The author's main message is that if a firm manages idiosyncratic risk, the correct cost of capital for the operating investment is not the firm's enterprise WACC, but rather the required return on the assets being funded. Using the case of a company with a single line of business that is evaluating an investment opportunity, the author demonstrates how to adjust the firm's overall WACC to find the cost of capital for the operating assets to be acquired. 2006 Morgan Stanley.