| Logic and weaknesses. | | | | risk the project bears will be negated ('diversified |
| The capital asset pricing model was originally | | | | away ') by other investments in their well diversified |
| developed to explain how the returns earned on | | | | portfolios. |
| shares are dependent on their risk characteristics. | | | | In practice it is found that large listed companies are |
| However, its greatest potential use in the financial | | | | typically highly diversified anyway and it is likely that |
| management of a company is in the setting of | | | | any unsystematic risk will be negated by other |
| minimum required returns (ie, risk- adjusted discount | | | | investments of the company that accepts it, thus |
| rates ) for new capital investment projects. | | | | meaning that investors will not require compensation |
| The great advantage of using the CAPM for project | | | | for its unsystematic risk. |
| appraisal is that it clearly shows that the discount | | | | Before proceeding to some examples it is important |
| rate used should be related to the project's risk. It is | | | | to note that there are tow major weaknesses with |
| not good enough to assume that the firm's present | | | | the assumptions.a) The company's shareholders may |
| cost of capital can be used if the new project has | | | | not be diversified. Particularly in smaller companies |
| different risk characteristics from the firm's existing | | | | they may have invested most of their assets in this |
| operations. After all, the cost of capital is simply a | | | | one company. In this case the CAPM will not apply. |
| return which investors require on their money given | | | | Using the CAPM for project appraisal only really |
| the company's present level of risk, and this will go | | | | applies to quoted companies with well diversified |
| up if risk increases. | | | | shareholders.b) Even in the case of such a large |
| Also, in making a distinction between systematic and | | | | quoted company, the shareholders are not the only |
| unsystematic risk, it shows how a highly speculative | | | | participants in the firm. It is difficult to persuade |
| project such as mineral prospecting may have a | | | | directors an employees that the effect of a project |
| lower than average required return simply because its | | | | on the fortunes of the company is irrelevant. After |
| risk is highly specific and associated with the luck of | | | | all, they cannot diversify their job. |
| making a strike, rather than with the ups and downs | | | | In addition to theses weaknesses there is the |
| of the market (ie, it has a high overall risk but a low | | | | problem that the CAPM is a single period model and |
| systematic risk). | | | | that it depends on market perfections. There is also |
| It is important to follow the logic behind the use of | | | | the obvious practical difficulty of estimating the beta |
| the CAPM as follows.a) The company assumed | | | | of a new investment project. |
| objective is to maximize the wealth of its ordinary | | | | Despite the weaknesses we will now proceed to |
| shareholders.b) It is assumed that these shareholders | | | | some computational examples on the use of the |
| all hole the market portfolio (or a proxy of it).c) The | | | | CAPM for project appraisal. |
| new project is viewed by shareholders, and | | | | 8. certainty equivalents. |
| therefore by the company, as an additional | | | | In this chapter we have determination of a risk- |
| investment to be added to the market portfolio.d) | | | | adjusted discount rate for project evaluation. One |
| Therefore, its minimum required rate of return can | | | | problem with building a premium into the discount rate |
| be set using the capital asset pricing mode formula.e) | | | | to reflect risk is that the risk premium compounds |
| Surprisingly, the effect of the project on the | | | | over time. That is, we implicitly assume that the risk |
| company which appraises it is irrelevant. All that | | | | of future cash flows increases as time progresses. |
| matters is the effect of the project on the market | | | | This may be the case, but on the other had risk may |
| portfolio. The company's shareholders have many | | | | be constant with respect to time. In this situation it |
| other shares in their portfolios. They will be content if | | | | could be argued that a certainty equivalent approach |
| the anticipated project returns simply compensate | | | | should be used. |
| for its systematic risk. Any unsystematic or unique | | | | |