Hello It’s about using the SML to estimate the discount rate for a capital project. it says: Simply using the company’s weighted average cost of capital (WACC) will overstate the required return for a conservative (low beta) project, and will understate the required return for an aggressive (high beta) project. If i make an example: Lets say WACC is 12% and my beta would be low, so the R of my project would be 10%. This would lead that if the WACC is used for the calucation, the value would be lower, so it would be understated. but it says overstate. can someone help?? sorry!! thanks!
WACC = rf + beta*(rm-rf) beta is low - so WACC is low. if Beta increased - WACC would increase - right. so at your new WACC - project’s value would be lower. So currently with the current WACC your project value is OVERSTATED.
it’s saying that if the WACC is 12%, when it’s a low beta project just like you said, the r of your project maybe should be 10%. so you by using that WACC of 12% are overstating the r of the project. should be 10, you used 12. other way around- high beta project, you maybe should use 15, you use 12… you’re understating the r.
Risk of the company correlates to the WACC. So if there is a specific project undertaking who’s risk is extremely high and you still use the company cost of capital WACC to find the NPV, then the denominator (WACC) is too low and hence the NPV estimation will be too high. For your ex: WACC = 12% beta is lower than avg company risk so the discount factor ® from the SML equation will be lower than 12% Denominator should be lower, but instead if you use company WACC (12%) which is too high for this low risk project, then the NPV will be too low. So basically you have underestimated and understates the NPV potential of the project.
but i thought if its a conservative project i use high discount factor, so the NPV is lower (because the denominator is larger) for a high risk project, i use a lower discount factor? and it just doesnt make sense with the low or high beta if it think like that! or does that sentence with “required return” not refer to the NPV?
You have to think about the two potential outcomes relative to one another. For a high beta project, you have to use a higher WACC to take into account the added risk, right? Let’s say that using this method, with the high beta adjusted WACC, the projected value of a project is 1 billion dollars. If you had NOT adjusted the WACC for the high beta, the WACC would be lower than it should be. With a lower, not-beta-adjusted WACC, the value of that same project will be larger than 1 billion dollars. As a result, the incorrect, unadjusted WACC in the second case will overstate the value of the project **relative to the correctly adjusted, i.e. larger, WACC.** Does that help?
I remember reading this part and it is confusing in the Schweser’s notes. I read the relevant section in CFAI and it makes things a lot clearer. Basically, if your WACC > RR and you are using WACC as the discount rate, your NPV is going to be lower. Meaning, you would have a higher chance to reject the project (due to insufficient NPV). Similarly, if your WACC < RR and you are using WACC as the discount rate, you will have a higher chance to accept the project (even if it has higher risk). The way I take this section is, don’t bother with the overstate and understate business in Schweser’s notes. What we really care in corporate finance is, are we accepting a project that has too much risk, or are we rejecting project that has good NPV and risk.
yellayella Wrote: ------------------------------------------------------- > but i thought if its a conservative project i use > high discount factor, so the NPV is lower (because > the denominator is larger) > > for a high risk project, i use a lower discount > factor? > > and it just doesnt make sense with the low or high > beta if it think like that! > > or does that sentence with “required return” not > refer to the NPV? Re-reading your post, you seem a bit confused by terminology. Dump the term conservative. It doesn’t really belong here. RISKY projects typically have the potential for a large return, but also a large risk. As a result, to properly value a RISKY project, you use a high discount factor - the same way an investor would have a higher required return for a risky stock. So for a RISKY project, you increase the WACC. This results in a risk-adjusted projected value that is lower than the value you would get if you did not risk-adjust your WACC. Without adjusting the WACC, your projected value could be huge, and you’d think that the project was the greatest thing since sliced bread until it blows up in your face since you didn’t factor in the risk.
ok thank you very much for your help!!