Logic and weaknesses.
The capital asset pricing model was initially developed to explain how the returns earned on shares are depending on their risk characteristics. However, its greatest potential use in the financial administration of a company is in the setting of minimum required returns (ie, risk- adjusted low cost rates ) for new capital investment projects.
The great advantage of using the CAPM for project appraisal is that it clearly shows that the low cost rate used must be associated to the project’s risk. It’s not adequate to assume that the agency’s current value of capital can be utilized if the new project has completely different risk characteristics from the agency’s present operations. After all, the cost of capital is solely a return which traders require on their money given the company’s present stage of risk, and this will go up if risk increases.
Additionally, 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 particular and related with the luck of making a strike, rather than with the ups and downs of the market (ie, it has a high total risk but a low systematic risk).
It is important to comply with the logic behind using the CAPM as follows.
a) The company assumed objective is to maximize the wealth of its strange shareholders.
b) It’s assumed that these shareholders all hole the market portfolio (or a proxy of it).
c) The new project is seen by shareholders, and subsequently by the company, as an additional funding to be added to the market portfolio.
d) Due to this fact, its minimal required rate of return could be set utilizing the capital asset pricing mode formula.
e) Surprisingly, the impact of the project on the corporate which appraises it is irrelevant. All that issues is the effect of the project on the market portfolio. The company’s shareholders have many different shares of their portfolios. They are going to be content material if the anticipated project returns simply compensate for its systematic risk. Any unsystematic or unique risk the project bears might be negated (‘diversified away ‘) by different investments of their well diversified portfolios.
In observe it is found that large listed corporations are typically highly diversified anyway and it is likely that any unsystematic risk will likely be negated by different investments of the company that accepts it, thus which means that buyers won’t require compensation for its unsystematic risk.
Earlier than proceeding to some examples it is essential to note that there are tow main weaknesses with the assumptions.
a) The company’s shareholders might not be diversified. Particularly in smaller companies they may have invested most of their belongings in this one company. In this case the CAPM is not going to apply. Using 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 are usually not the only contributors in the firm. It’s tough to persuade directors an staff that the effect 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 model and that it depends on market perfections. There is additionally 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 using the CAPM for project appraisal.
8. certainty equivalents.
In this chapter now 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 will increase as time progresses.
This stands out as the case, however on the other had risk could also be constant with respect to time. In this situation it could be argued that a certainty equivalent approach needs to be used.
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