18.5 Allocating the Cost of Capital

Compare profitability among the BU by allocating cost of capital for each BU

2 possible definitions for cost of capital \(C_j\)

  1. Option pricing: Value of the right to call upon the capital of the firm

    • Added value = \(P_j - C_j\)

    • Caveat: Difficult to value as the timing is not fixed in advanced

  2. Market value of a stop loss that attach at zero profits for the BU

    1. Start with expected value of the stop-loss

    2. Use probability transform and theory of pricing in incomplete markets (e.g. MET)

    • Practical estimate: Mean + 30% of s.d. would apply a consistent risk load to the BU