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)