Logic and weaknesses.
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 in the financial management of a company is in the setting of minimum required returns (ie, risk- adjusted discount rates ) for new capital investment projects.
The great advantage of using the CAPM for project appraisal is that it clearly shows that the discount rate used should be related to the project’s risk. It is not good enough to assume that the firm’s present 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 which investors require on their money given the company’s present 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 such as mineral prospecting may have a lower than average required return simply because its risk is highly specific and associated with the luck of making a strike, rather than with the ups and downs of the market (ie, it has a high overall risk but a low systematic risk).
It is important to follow the logic behind the use of the CAPM as follows.
a) The company assumed objective is to maximize the wealth of its ordinary shareholders.
b) It is assumed that these shareholders all hole the market portfolio (or a proxy of it).
c) The new project is viewed by shareholders, and therefore by the company, as an additional investment to be added to the market portfolio.
d) Therefore, its minimum required rate of return can be set using the capital asset pricing mode formula.
e) Surprisingly, the effect of the project on the company which 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 content if the anticipated project returns simply compensate for its systematic risk. Any unsystematic or unique risk the project bears will be negated (‘diversified away ‘) by other investments in their well diversified portfolios.
In practice it is found that large listed companies are typically highly diversified anyway and it is likely that any unsystematic risk will be negated by other investments of the company that accepts it, thus meaning that investors will not require compensation for its unsystematic risk.
Before proceeding to some examples it is important to note that there are tow major weaknesses with the assumptions.
a) The company’s shareholders 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 apply. Using the CAPM for project appraisal only really applies to quoted companies with well diversified shareholders.
b) Even in the case of such a large quoted company, the shareholders are not the only participants in the firm. It is difficult to persuade directors an employees that the effect of a project on the fortunes of the company is irrelevant. After all, they cannot diversify their job.
In addition to theses weaknesses there is the problem that the CAPM is a single period model and that it 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 appraisal.
8. certainty equivalents.
In this chapter we have determination 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 is, we implicitly assume that the risk of future cash flows increases as time progresses.
This may be the case, but on the other had risk may be constant with respect to time. In this situation it could be argued that a certainty equivalent approach should be used.