In project financing, equity investors have the junior-most claim on the project cash flows and project assets and as a result their risk exposure is higher than the lenders, in case of debt it involves contractual payment obligations. For estimating the required return on equity, the concept of capital-asset pricing model is a useful technique. As per the CAPM concept, an investor will be willing to take on a risky asset if the return is commensurate with degree of risk exposure to the investor. The required rate of return is expressed as the sum of risk-free rate plus a risk premium, as given below:
Where, rj = Return on equity (or cost of equity, Costequity)
rf = Risk-free return
βj = Beta
rM = Expected return on market portfolio
Beta is a measure of asset's riskiness and reflects the correlation between the asset's return and those of the market portfolio. The risk premium can be considered as the additional return investors require to compensate for bearing additional risk.
The weighted average cost of capital (WACC) can be determined in the following manner:
