Calculating Project Return using CAPM Concept


Going over some of the corporate finance material, it seems there are two ways to estimate the required return on an investment project.

  1. Use the Company’s WACC

  2. Calculate the Rate using Project Beta in the CAPM.

I would just like to make sure if I have this right:

Normally we would use CAPM (with the general company Beta) to calculate the required return on equity. We then weight this rate by the proportion of equity in the company’s capital structure and add it to the wieghted cost of debt to obtain the WACC, which is the company’s general cost of capital.

The project return uses the CAPM formula but replaces company beta with project beta.

So does this mean the project beta already accounts for the sources of finance that fund the project (i.e. considers both debt and equity and their relative weights)? And if that is the case, even if the project were entirely financed by debt we could still use the Project Beta?

If the project has higher risk than the company, then the project Beta should be used. This is only half part of the WACC story. It accounts for Equity only.

In any case, we should be still using WACC.

Any other thaughts guys?

WACC might overstate/ understate the NPV if the particular projects risk is higher(project beta>Company’s BETA) or lower(project beta The project’s beta should be used to determine discount rates when the risk of a project is different from the risk of the overall company.

If the project’s risk is significantly different from the overall company risk then we would calculate a discount rate using the CAPM formula but the beta is that which relates to the specific project and not the company.

My question is, does this project beta account for the risk taken on by all providers of capital? Because as I understand it, the rate we get using the Project CAPM (viewing the project as an asset) is the discount rate (R-Project) we use to find the NPV.

In other words, instead of using WACC, we use R-Project. Since the DCF method does not account for interest expense in calculating the cash flows it is accounted for in the discount rate which means R-Project is the return required by all providers of capital.

Surely CAPM only gives you the cost of the project equity, if it was partly debt funded you would need to calculate a new WACC… I think.

I see what your saying. I was just a little confused by the example on page 53 of Corp Finance Book. So to clear it up, the CAPM return calculated from the project Beta is the project specific risk born by the equity investors only, and then this project equity return will replace the company-wide equity return in calculating the WACC to discount the project cash flows? So essentially you woul have a project WACC at the end?

Also, if a project’s risk is higher, shouldn’t debt holders be compensated accordingly as well?

The more I read into it, the more it makes sense to think of the entire project as an asset. We don’t actually use CAPM but the SML. And in the book it says we use the SML to find the required rate of return.

If you look at example 9 on page 52, the rate they derive from the SML is 10.44%, then they proceed to discount the projects cash flows at this rate. So unless they are assuming 100% equity financing, the SML derived rate takes the place of WACC rather than being an adjustment of the WACC.

This would mean the project beta has to account for the risks born by all providers of capital, not just equityholders.

Any thoughts?

This is what they are trying to tell you:

Company has a WACC - which is based on entire firm. If you go by that - you might end up using too high of a hurdle rate and some projects which are otherwise positive NPV projects and would add on to profitability of the firm - would get MISSED completely.

So whats the bottom line…do we use WACC or just the required return on equity for projects that have differnt risk profiles than that of the company?

Can anyone help out?

It’s clear that using WACC is not appropriate in some cases because it over or understates the risk of the project. What would we use instead though? The book says to use CAPM with a specific project beta to determine the required rate of return for the project (R project).

Is R project the required rate of return for the WHOLE project (Debt + Equity) or the required rate of return for the EQUITY investors in the specific project only? The confusion comes from the fact that CAPM is normally used to get the equity required rate of return …

Think about it for a little bit.

If Rproject < RFirm

and the same debt financing in same proportion is used ->

WACC Project will be < WACC Firm.

You are evaluating the project - however using the Firm’s WACC would cause a high hurdle rate to be used - and you would give up the project because of the hurdle rate constraint.

If you read the text - I am pretty sure it says this above in bold. I would recommend you pick up the text and read the “material” there. It states this in quite so many words, and it does not take too much time either. [Not sure if you are depending too much on Schweser for this part].

I’ve been thinking about this all day at work and read the “material” of the book (The Official CFA 2012 Level II Book Volume 3 ordered straight from the CFA Institute just to be clear) many times over…

As I have said and as you have said, using the firm WACC is less appropriate for a specific project because it has a different risk compared to the whole company. What I want to be clear about is the alternative rate to use.

The book doesnt say anything about a WACC project which is why I am asking if such a thing exists. The way I understood the book, the CAPM estimates the whole discount rate for the entire project, when they use the project beta.

Now if WACC project does exist … could someone then explain why we should assume the cost of debt doesnt change for a specific project? The project WACC seems to only change because of the equity portion.

I don’t think there is any reason the cost of debt couldn’t be adjusted, but most often the price of a companies debt is going to be based on the company as a whole, because Debt just comes down to company’s ability to pay it. So if you were going to adjust the cost of debt for the project then you would be assuming that the project was large enough and risky enough that it would affect the company’s ability to either sell bonds or get a bank loan.

I’ve always thought that discounting FCFE by the cost of equity is better than discounting FCFF by the WACC and that takes care of your cost of Debt assumptions, but that brings up other issues.

If I remember right - even if you made an “all equity” investment in the project. Even by that standard - you would make a wrong decision if you went with the company’s beta adjusted rate of return - since the beta project is different (may be higher or lower) than the beta of company.

If beta Project > beta company -> but project is profitable - you would go with company beta - take on the project but your projections of addition to the bottom line would be lower than what they might have been. or you might find that the company actually is not profitable at all … since it is riskier.

if beta project < beta company - you might use company beta - take company’s higher rate of return - discount project and consider that this project is unprofitable… and ignore it.

I think I got the impacts above right … in any case - you end up making wrong decisions.

Hi, thanks for your reply. So to be sure, the idea is to adjust the WACC to better reflect the project risk and this is done by adjusting the required return on equity using the project beta in the CAPM. For the return on debt, we use the firm’s overall cost of debt. Then we proceed to weight the two returns to obtain a project-specific WACC?

It makes sense but I still don’t entirely buy it. If capital budgeting is only concerned with the marginal costs of investing in a single project, don’t you think it would be better to adjust the return on debt before calculating a project specific WACC? As I look it, using a firm-wide cost of debt and project-specific cost of equity only gets rid of half the problem - that is we would be under / overstating the cost of debt that is appropriate for a separate project.

You’re going to get your cost of debt from what the company can sell bonds for or what you can get a bank loan for, and that number isn’t really going to change via one project. Unless that project is somehow started as it’s own corporate entity and is bankruptcy remote from the parent.

So say we are researching a project and a bank has come to us and said we will give you a loan at 5%, with the assets of the company as a whole for collateral. Now we need to know what project we’re going to finance with that loan and we plug those interest costs into a FCFE model and discount those projects back to NPV. If we decide that some of those projects are more risky than we initially though are we going to go back and increase those interest payments? That would be crazy, we’ve already got that loan locked up, so why would we increase those cashflows to represent risk? That’s the bank’s job. We need to represent our increased/decreased risk in the E® on equity.

Basically the cost of debt is usually given to you, and is based on the assets and liquidity of the firm as a whole. So the blunt of increases/decreases in risk should be taken by the equity holders, therefore we adjust E® for changes in the riskiness of a project.

Obviously if a project was large enough to affect the solvency of the entire company then we would want to take into account a possible averse reaction to the cost of debt facing the firm as a whole.

In practice I agree that this is the best way to proceed and if it’s FCFE we’re talking about, then project E® is for sure the best discount rate to use because the interest expense has already been paid.

But in theory we are interested in the true discount rate for a single project and we have to view the project in isolation. The required returns from the project have to come solely from that project’s expected future cash flows. Also financing costs are typically ignored in capital budgeting (we don’t deduct interest from the cash flows) as the cost is reflected in the discount rate. This is why I believe the cost of debt for a project should be adjusted for that project rather than using the general company cost of debt.

Just to illustrate: If a reputable company wants buy a factory in a politcally unstable country with the threat of its assets being nationalized, in practice the loan from the bank will pronbably consider the overall financial condition of the company’s global operations. However, for the specific investment in the unstable country don’t you think the true return on debt should be a lot higher assuming the returns would have to be paid solely from the investment in that factory?

you are assuming the company is going to take a fresh debt to go in there… aren’t you?

but really does every company do that?

From the point of view of this particular topic - this has gone on for too long…

I guess no one saw my post above … so am reposting it.

I am assuming a ALL EQUITY project financing here … below …

If beta Project > beta company -> but project is profitable - you would go with company beta - take on the project but your projections of addition to the bottom line would be lower than what they might have been. or you might find that the company actually is not profitable at all … since it is riskier.

if beta project < beta company - you might use company beta - take company’s higher rate of return - discount project and consider that this project is unprofitable… and ignore it.