Application Of The CAPM To Project Appraisal
The capital asset pricing model was originally developed to explain how the returns earned on shares are dependent on their risk characteristics. However, its greatest potential use within the monetary management of a company is in the setting of minimal required returns (ie, risk- adjusted low cost rates ) for new capital funding projects.
The great advantage of using the CAPM for project appraisal is that it clearly shows that the low cost rate used ought to be associated to the project's risk. It is not good enough to imagine that the agency's present price of capital can be used if the new project has different risk characteristics from the agency's present operations. After all, the cost of capital is just a return which buyers require on their cash given the corporate's current level of risk, and this will go up if risk increases.
Also, in making a distinction between systematic and unsystematic risk, it shows how a highly speculative project resembling mineral prospecting may have a decrease than average required return simply because its risk is highly specific and related with the luck of making a strike, somewhat than with the ups and downs of the market (ie, it has a high overall risk but a low systematic risk).
It is very important follow the logic behind the usage of the CAPM as follows.
a) The company assumed goal is to maximize the wealth of its atypical shareholders.
b) It is assumed that these shareholders all hole the market portfolio (or a proxy of it).
c) The new project is considered by shareholders, and therefore by the company, as an additional funding to be added to the market portfolio.
d) Therefore, its minimal required rate of return can be set using the capital asset pricing mode formula.
e) Surprisingly, the impact of the project on the company which appraises it is irrelevant. All that issues is the impact of the project on the market portfolio. The corporate's shareholders have many different shares in their portfolios. They are going to be content if the anticipated project returns merely compensate for its systematic risk. Any unsystematic or distinctive risk the project bears can be negated ('diversified away ') by other investments in their well diversified portfolios.
In observe it is discovered that giant listed corporations are typically highly diversified anyway and it is likely that any unsystematic risk might be negated by other investments of the company that accepts it, thus that means that investors is not going to require compensation for its unsystematic risk.
Before proceeding to some examples it is essential to note that there are tow major weaknesses with the assumptions.
a) The corporate's shareholders may not be diversified. Notably in smaller firms they may have invested most of their belongings in this one company. In this case the CAPM won't apply. Utilizing the CAPM for project appraisal only really applies to quoted firms with well diversified shareholders.
b) Even in the case of such a big quoted firm, the shareholders will not be the only individuals in the firm. It's difficult to persuade directors an staff that the impact of a project on the fortunes of the corporate is irrelevant. After all, they can't diversify their job.
In addition to theses weaknesses there may be the problem that the CAPM is a single interval mannequin and that it depends on market perfections. There may be also the apparent practical problem of estimating the beta of a new investment project.
Despite the weaknesses we are going to now proceed to some computational examples on the usage of the CAPM for project appraisal.
8. certainty equivalents.
In this chapter we have willpower of a risk- adjusted discount rate for project evaluation. One problem with building a premium into the discount rate to reflect risk is that the risk premium compounds over time. That's, we implicitly assume that the risk of future cash flows increases as time progresses.
This would be the case, but on the other had risk could also be fixed with respect to time. In this situation it could possibly be argued that a certainty equal approach ought to be used.
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