Logic and weaknesses.
The capital asset pricing model was originally developed to explain how the returns earned from stocks depend on their risk characteristics. However, its greatest potential use in a company’s financial management is in setting minimum required returns (ie, risk-adjusted discount rates) for new capital investment projects.
The great advantage of using the CAPM for project evaluation is that it clearly shows that the discount rate used must be related to the risk of the project. It is not enough to assume that the firm’s current cost of capital can be used if the new project has different risk characteristics from the firm’s existing operations. After all, the cost of capital is simply a return that investors require on their money given the company’s current level of risk, and this will increase if risk increases.
Furthermore, by making a distinction between systematic and unsystematic risk, he shows how a highly speculative project, such as mineral prospecting, can have a lower-than-average required return simply because its risk is highly specific and associated with the luck of making an investment. strike, rather than on the ups and downs of the market (ie, it has high overall risk but low systematic risk).
It is important to follow the logic behind the use of the CAPM as follows.
a) The objective assumed by the company is to maximize the wealth of its ordinary shareholders.
b) It is assumed that all these shareholders form the market portfolio (or a proxy for it).
c) The new project is seen by the shareholders, and therefore by the company, as an additional investment to incorporate into the market portfolio.
d) Therefore, your minimum required rate of return can be established using the capital asset valuation mode formula.
e) Surprisingly, the effect of the project on the company appraising it is irrelevant. All that matters is the effect of the project on the market portfolio. The company’s shareholders have many other shares in their portfolios. They will be happy if the anticipated project returns simply by offsetting its systematic risk. Any unsystematic or unique risk that the project bears will be offset (“diversified”) by other investments in your well-diversified portfolios.
In practice, it is found that large publicly traded companies are often highly diversified anyway and any unsystematic risk is likely to be offset by other investments of the company accepting it, meaning that investors will not require compensation. because of its unsystematic risk.
Before proceeding with some examples, it is important to note that there are two major weaknesses with the assumptions.
a) The shareholding of the company may not be diversified. In particular, in smaller companies, they may have invested most of their assets in this one company. In this case the CAPM will not be applied. The use of the CAPM for project evaluation only really applies to listed companies with well-diversified shareholders.
b) Even in the case of such a large listed company, the shareholders are not the only participants in the company. It’s hard to persuade managers and employees that a project’s effect on the company’s fortunes is irrelevant. After all, they cannot diversify their work.
Added to these weaknesses is the problem that the CAPM is a single-period model and depends on market perfections. There is also the obvious practical difficulty of estimating the beta of a new investment project.
Despite the weaknesses, we will now proceed to some computational examples on the use of the CAPM for project evaluation.
8. certainty equivalents.
In this chapter we have the determination of a risk-adjusted discount rate for the evaluation of projects. One problem with constructing a premium discount rate to reflect risk is that the risk premium builds up over time. That is, we implicitly assume that the risk of future cash flows increases as time passes.
This may be the case, but on the other hand the risk may be constant over time. In this situation, it could be argued that an equivalent certainty approach should be used.
