CAPM and a Capital Project’s Discount Rate
- Stand-alone project analysis (sensitivity, scenario, and simulation analysis) looks at a project’s risk in isolation.
- Projects also have exposure to market risk and company management should consider how a project’s future cash flows will correlate with market returns (think beta).
- A project with heightened sensitivity to market changes (i.e. higher market risk) should be discounted with a higher cost of capital. Alternatively, a lower market risk project could be discounted with a lower rate.
- A common way to incorporate market risk into capital budgeting analysis is by applying the principles of the capital asset pricing model (CAPM).
- In applying CAPM to capital budgeting, the analyst will need to determine the project’s beta, the risk free rate of return and the market rate of return.
- The project’s discount rate in calculating NPV will then be determined by the following equation:
r project = r risk free + β project ( r market – r risk free)
Get smart about tech at work.
As a non-technical professional, learn how software works with simple explanations of tech concepts. Learn more...
- CFA Level 2: Corporate Finance Part 1 – Introduction
- Introduction to Capital Structure and Leverage
- Introductory Capital Budgeting Remarks
- Expansion Projects vs. Replacement Projects and Cash Flows
- Impacts of Depreciation Method Choice on Capital Budget Analysis
- Inflation and Capital Budgeting
- Mutually Exclusive Capital Projects with Unequal Lives
- Equivalent Annual Annuity (EAA) Approach
- Least Common Multiple of Lives Approach
- Stand Alone Risk and Capital Projects
- CAPM and a Capital Project’s Discount Rate
- Capital Projects and Real Options
- Common Pitfalls in Capital Budgeting
- Capital Budgeting Alternatives to NPV and IRR Analysis
- Modigliani-Miller and Capital Structure Theory
- Evaluating Capital Structure Policy
- International Differences in Financial Leverage
- Dividend and Share Repurchase Policies
- Factors Affecting Corporate Dividend Policy Decisions
- Signals from Dividend Policies