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 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 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 that 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, he shows how a highly speculative project, such as mineral prospecting, can have a below-average required return simply because its risk is very specific and associated with the luck of making a decision. strike, rather than with the ups and downs of the market (i.e., 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 thereof).
c) The new project is seen by the shareholders, and therefore by the company, as an additional investment to be incorporated into the market portfolio.
d) Therefore, your minimum required rate of return can be established using the capital asset pricing mode formula.
e) Surprisingly, the effect of the project on the company that appraises 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 offsetting their systematic risk. Any unsystematic or unique risk that the project bears will be offset (“diversified”) by other investments in its 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 investors will not require compensation. because of its unsystematic risk.
Before continuing 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. Particularly 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, 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.
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 discount rate premium 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 passes.
This may be the case, but on the other hand the risk may be constant with respect to time. In this situation, it could be argued that a certainty equivalent approach should be used.
