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 the financial management of a company is the establishment of required minimum returns (i.e., 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 company’s current cost of capital can be used if the new project has different risk characteristics from the company’s existing operations. After all, the cost of capital is simply a return investors require on their money given the company’s current level of risk, and this will increase as risk increases.
Furthermore, by making a distinction between systematic and unsystematic risk, it shows how a highly speculative project such as prospecting for minerals can have a below-average required return simply because its risk is highly specific and associated with the luck of striking, rather than with the ups and downs of the market (i.e. you have high overall risk but low systematic risk).
It is important to follow the logic behind using 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 monopolize 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 be added to the market portfolio.
d) Therefore, your required minimum rate of return can be established using the capital asset pricing mode formula.
e) Surprisingly, the effect of the project on the company evaluating it is irrelevant. The only thing that matters is the effect of the project on the market portfolio. The shareholders of the company have many other stocks in their portfolios. They will be happy if the project’s anticipated returns simply outweigh its systematic risk. Any unsystematic or unique risk assumed by the project will be nullified (‘diversified’) by other investments in its well diversified portfolios.
In practice, it is found that large publicly traded companies are usually highly diversified anyway and any unsystematic risk is likely to be offset by other investments of the accepting company, meaning that investors will not require compensation. for its unsystematic risk.
Before moving on to a few examples, it is important to note that there are two major weaknesses with assumptions.
a) The shareholders of the company cannot be diversified. Particularly in smaller companies, they may have invested most of their assets in this company. In this case, the CAPM will not apply. Using the CAPM for project appraisal 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 is difficult to persuade managers and employees that the effect of a project on the fortunes of the company is irrelevant. After all, they cannot diversify their work.
In addition to these weaknesses, there is the problem that the CAPM is a single-period model and that it depends on market improvements. There is also the obvious practical difficulty of estimating the beta of a new investment project.
Despite the weaknesses, we will now turn to some computational examples of using the CAPM for project evaluation.
8. certainty equivalents.
In this chapter we have the determination of a risk-adjusted discount rate for project evaluation. One problem with incorporating a premium into the discount rate to reflect risk is that the risk premium accumulates over time. That is, we implicitly assume that the risk of future cash flows increases as time progresses.
This may be the case, but on the other hand, the risk can be constant over time. In this situation, it could be argued that an equivalent certainty approach should be used.