What is the effect on capital costs when sustainability risks rise?

What is the effect on capital costs when sustainability risks rise?

• A. Lower cost of capital and discount rates, boosting valuations
• B. Higher cost of capital and discount rates, raising hurdle rates and lowering valuations
• C. No impact on cost of capital
• D. Regulatory penalties increase but do not affect capital costs

Answer: (B)

When sustainability risks rise, investors see the company as riskier, so they demand higher returns on both debt and equity. That pushes up the overall cost of capital (the WACC). In valuations, cash flows are discounted at this rate, so a higher discount rate reduces the present value of future cash flows and lowers valuations. For investment decisions, hurdle rates are tied to the cost of capital and risk premium, so a higher risk profile raises the hurdle rate and can cause fewer projects to pass the hurdle, further decreasing valuations. In short, rising sustainability risk increases capital costs and discount rates, which tends to lower valuations.

When sustainability risks rise, investors see the company as riskier, so they demand higher returns on both debt and equity. That pushes up the overall cost of capital (the WACC). In valuations, cash flows are discounted at this rate, so a higher discount rate reduces the present value of future cash flows and lowers valuations. For investment decisions, hurdle rates are tied to the cost of capital and risk premium, so a higher risk profile raises the hurdle rate and can cause fewer projects to pass the hurdle, further decreasing valuations. In short, rising sustainability risk increases capital costs and discount rates, which tends to lower valuations.