The reason why risks is hidden is because

we have been taking the discount rate as given, okay?

That's really the main reason why we

haven't found out risk yet in this course, okay?

I've always been telling you the discount rate is 10%, is 8%, is 7%, right?

So the idea, and this is the key idea in finance,

is that the discount rate should reflect the risk of the project.

That is the number that is going to capture risk for us, okay?

So what we're gonna talk about now is how do we use,

I mean how do we implement this concept, okay?

To understand this better, let's go back to model three, and

think about the internal rate of return again, right?

What we learned in model three is that if the IRR is bigger than the discount rate,

then the NPV is positive, okay?

So you have to compare the IRR of a project with the discount rate.

If you're thinking about risk, right?

What we're learning now is that the discount rate captures risk.

So another way you can think about this statement is that

the higher the risk of a project.

If a project is more risky, right?

Then it's going to take a higher rate of return

to turn this project into a good project, okay?

So to make a project positive NPV, if risk is high,

you're going to need a high rate of return, okay?

So that's an intuitive way for you to think about this relationship, right?

It turns out that measuring the risk of a project, measuring the risk of a company,

measuring the risk of an investment is one of the key topics in finance.

In fact, you spend a lot of your time in an investments

course when you're studying investments rather than corporate finance.

A lot of the course is typically devoted to this topic, okay?

What we will do in the next few slides is to do a review so

our course is self-contained and

you know how to incorporate risk into corporate finance valuation, okay?

But if you would like a more in-depth discussion, what I

recommend is that you have a look at Scott Weisbenner's investments course, okay?

Which is also available, and it does have a much more in-depth discussion of how we

measure risk in finance, which really is the same idea as we're gonna use here

to incorporate risk into corporate finance valuation, okay?

Let me give you the bottom line first,

which you might remember if you took Scott's class already, okay?

The way that we're going to measure risk, for a company project,

for a company, is by using the weighted average cost of capital formula, okay?

If you haven't seen this, it's going to look foreign.

If you have, it's going to look familiar.

That's why I want to do a review of this anyway.

Even if you took Scott's class, I think it might be useful to do a review and

think about the weighted average cost of capital from

a corporate finance point of view, okay?

The name says it all.

The weighted average cost of capital is a weighted average, right?

You have the required return on that.

And then you're multiplying this by the fraction of

the value of the company that comes from that, okay?

It's debt over value where value is defined as debt plus equity, okay?

And then you have the required return on the equity multiplied by

the fraction of the value of the company that comes from equity, okay?

So the E here is going to be the market value of equity.

So it's just a weighted average.

What I want to do in the next few slides is to do an example with you, okay?

And I'm gonna use this example to review the key concepts and

as we've been doing in this course so far,

I want to use data from a real world company to do this, okay?

Specifically, what we are going to do is we're going to computer the WACC for

Pepsico as of June 2015.

We need to do this for a certain period of time because, as you just saw the formula,

the WACC depends on the value of the company, so we have to measure

the value of the company and some of the market data for a specific period of time.

But the ideas are the same.

You can use the same principle, the same calculation

to compute weighted average of capital for any company in any period of time, okay?