Risk Management and the Cost of Capital for Operating Assets

This paper compares two alternative strategies, paid-in risk capital and insurance, which firms use to financially manage a catastrophic risk. The paper first presents a reminder that in the traditional cost of capital model, neither strategy can improve shareholder wealth by reducing a firm’s overall (weighted average) cost of capital. For both strategies, the paper then shows how to adjust a firm’s observed overall cost of capital to find the cost of capital that should be used in capital budgeting for a firm’s operating assets. In addition, the paper reviews some issues of deadweight costs of both strategies