CAPM_in_project_appraisal

USING CAPM IN
PROJECT APPRAISAL
PROJECT SPECIFIC DISCOUNT RATES
CAPM AND PROJECT
APPRAISAL
CAPM can be useful in determining a
discount rate when the project risk is
different from that of the company’s
normal business risk.
The logic behind CAPM is as follows:
◦ It has the objective of maximising
shareholder’s wealth
◦ Rational shareholders hold well diversified
portfolio
◦ Any new project is just another investment in
the portfolio
◦ CAPM can set the shareholder’s required return
on the project.
Illustration
Cooper Co is an all equity company with
a beta of 0.8. It is appraising a one year
project which requires an outlay now of
$1000 and will generate cash in one
year with an expected value of $1250.
The project has a beta of 1.3, Rf rate of
10% and Rm = 18%.
What is the firm’s current cost of equity?
What is the minimum required return of
the project?
Is the project worthwhile?
CAPM and gearing risk
The gearing of a company will affect the risk
of its equity. If a company is geared its
financial risk is higher than for an all equity
firm.
Therefore, value of beta of the geared firm
will be higher than the beta value of a similar
ungeared company’s equity.
Therefore CAPM is consistent with MM’s
proposition that as gearing rises, the cost of
equity rises to compensate the shareholders
for the extra risk.
This is reflected in the company’s beta factor.
Geared Beta and Ungeared
Beta
Amathematical relationship can
be established between an
ungeared company (all equity) and
a geared company (has debt and
equity).
Beta of Ungeared Co
Debt is assumed to be risk free
and its beta value is taken as
zero. Therefore the formula
reduces as follows:
Illustration 2
Train plc is an all equity financed established
company experienced in the provision of
training courses. Shares in Train have a beta
value of 1.2. The directors of Train plan to
expand their business by buying hotels which
are located near their training centres. Thirté
plc is a listed hotel company with zero
gearing. Its shares have a beta value of 1.5.
The market premium for risk is 8% and the
risk-free rate is 4%.
Required:
What cost of equity should go into the NPV to
appraise the new investment in hotels?
Ungearing and Regearing
Betas
The process of converting
equity beta of geared firm to
equity beta of a ungeared
firm is referred to as
ungearing while the
process of converting equity
beta of a ungeared firm to
equity beta of a geared firm
is regearing.
The concept of ungearing and
regearing is applied in the
following situations:
When there is a change in the firm’s
capital structure
When there is a change in the
corporate tax rate
When computing adjusted NPV
When the company is diversifying
away into a new industry that has a
different risk.
Steps in the calculation
1. Locate suitable proxy companies
2. Determine the equity betas of the
proxy companies, their gearings and
tax rates.
3. Ungear the proxy equity betas to
obtain asset betas.
4. Calculate an average asset beta
5. Regear the asset beta
6. Use the CAPM to calculate a project
specific cost of equity.
Illustration
XYZ plc capital structure as at 31/12/04 was as
follows: $M
Ordinary share 200
capital (par
value $1)
Retained profits 250
Capital reserves 100
8% term loan 400
Capital employed 950
The shares of the firm are currently at $6 ex div.

The risk free rate is 5.5% while market return is
13.5%. The equity beta of the firm is 1.45 and tax
30%.
Required:
XYZ cont.
The firm is contemplating changing its
capital structure as follows:
I. Borrow additional debt to repurchase
stock. This will change the debt-equity
ratio to 45:55
II. Issue new ordinary shares to raise
equity capital to repay the existing
loan changing the debt-equity ratio to
10:90
Required:
Compute the firm’s WACC under each
alternative change in capital structure
Illustration 2
Cycle land is a manufacturing sector and
its equity beta is 0.85. The firm wants to
diversify into agricultural sector which
has an industrial beta of 1.35 due to
high systematic risk. The gearing of the
firm by market values is 70% equity,
30% debt but in agricultural sector, the
industrial gearing is 85% equity, 15%
debt where the debt level is lower due to
high business risk. The risk free rate is
6% and the market portfolio is expected
to yield 12%.
Required:
Determine the discount rate to be
used to evaluate the new
investment assuming:
a) It will be financed in proportion
to the debt equity mix of the
firm
b) It will be financed with 50%
equity and 50% debt. Cycle land
has a 10% bank loan.
Limitations of using CAPM in
project appraisal
Itis difficult to identify other firms with
similar operating activities
Estimates of beta values from share
prices are not wholly accurate
There may be differences in beta values
between firms due to
◦ Different cost structures
◦ Size difference
◦ Debt capital not being risk free
Failure to provide growth opportunities
for the firm whose beta is being
estimated.

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USING CAPM IN

The shares of the firm are currently at $6 ex div.

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