Handout 10: Applying the CAPM to Capital Budgeting Corporate Finance, Sections 001 and 002 Previously we calculated

net present value given a discount rate r, without discussing where r came from. One major reason why we are interested in the CAPM is it tells us what r should be. Result 1: Consider a rm that has no debt. Consider a project in the same line of business as the rms existing projects. Assume that the CAPM is true. Then the cost of capital of the rm is = Rf + ( R M Rf ) R
2 where is Cov(R, RM )/M , calculated for returns R on the rms equity.

In other words, when deciding to take a project with cash ow C0 today and expected 1 , C 2 , . . ., the rm should calculate the NPV of the project as: future cash ows C

NPV = C0 +
t=1

t C )t . (1 + R

is the discount rate for the future payos. To maximize rm value, the rm so R should accept the project if NPV> 0, otherwise the rm should reject the project. Result 1 says that the discount rate should come from the CAPM. Why is this true? To understand why result 1 is true, we review the basics of the NPV decision in the single payo case: Suppose the rm has access to a project that costs C0 = $1000 this year and will pay C1 for sure next year. What is the alternative to investing in the project? Investing in the riskless asset Rf (or equivalently, putting money in bank). 1

 If the rm invests at Rf , the payo is $1000(1 + Rf ) next year The rm should take the project only if it oers a greater payo than investing in the the riskfree asset, i.e. only if C1 > $1000(1 + Rf ) This is the same as asking whether NPV = C0 + C1 /(1 + Rf ) = 1000 + C1 /(1 + Rf ) > 0. This justies the NPV rule for riskfree payos. Now suppose that the payo next 1 . How does the argument change? year is risky. Its expected value is C The rm should only invest in the project if it oers a higher return than the alternative given the level of risk. It is not enough that the project oers a higher return that the riskfree rate because a riskless payo is more valuable than a risky payo, all else equal. The rm could put the $1000 in a stock portfolio that has the same as the rm. The stock portfolio would then have the same risk as the project. According to the CAPM, the rate of return on the portfolio must be = Rf + ( R M Rf ) R Therefore if the rm puts $1000 into this portfolio, the expected payo will be ) $1000(1 + R The rm should take the project only if it oers greater value than investing 1 > C0 (1 + R ). Clearly this is the same as in the portfolio. That is, only if C asking 1 /(1 + R ) = 1000 + C 1 /(1 + R ) > 0. NPV = C0 + C 2

If the NPV is greater than zero, accepting the project will increase the value of the rm (if the rm invests in the asset with return R, the value of the rm is unchanged). Note: We use to measure the amount of risk in the project. Why? Because if shareholders hold well-diversied portfolios only systematic risk matters to them. An increase in idiosyncratic risk will be diversied away. The multi-payo case works similarly to the single-payo case. We have just shown Result 1. In Result 1 we have made two important simplifying assumptions. The rst is that the project is in the same line of business as the rm. The second is that the rm has no debt. Making both of these assumptions allowed us to use the estimated from the rms stock. If either of these assumptions do not hold, then it is not correct to discount using the required rate of return on the rms stock. Similar reasoning to Result 1 tells us that if a rm is embarking on a project in a new line of business, the rm should use the for this new line of business, rather than the estimated from the rms stock. The estimated from the rms stock represents the risk of the existing businesses, not the new business. For example, the computer software industry has a of about 1.25. If a software company decides to invest in building hardware, the company should not use a of 1.25. Rather the company should use the for the hardware industry of (about) 1.80. The higher reects the fact that, in entering the hardware industry, the rm is taking on a riskier project and thus the cash ows need to be discounted at a higher rate.

What happens when the rm contains debt as well as equity? This leads us to Result 2: Result 2 Assume the market value of the rms debt is D and the market value of the rms equity is E . Let E = beta on rms equity D = beta on rms debt Assume there are no taxes and that the CAPM is true. Consider a project in the same line of business as the rms existing projects. Then the cost of capital for that project equals A = R E D RE + RD D+E D+E (1)

E is the equity cost of capital: where R E = Rf + E (R M Rf ) R D is the debt cost of capital: and R D = Rf + D (R M R f ). R A is the Weighted Average Cost of Capital (or WACC). Note: The rate of return R A the proper discount rate to use? Because it is the required rate of Why is R return on the rms assets. For concreteness, consider Citigroup. We can think of Citis assets as a portfolio of Citis debt and Citis equity. The portfolio weights are XE = for Citis equity and XD = D D+E 4 E D+E

for Citis debt. As we learned from portfolio theory, the expected return on this portfolio is A = XE R E + XD R D . R So (1) follows from substituting in XE and XD . A Because the new project has the same risk prole as the existing projects, R must also be the required rate of return on the new project. This shows Result 2. Using formulas from portfolio theory, we can derive an equation for the of Citi as a whole. This is sometimes useful in calculating WACC. We call this the asset and label it A . Because the portfolio is the weighted average of the underlying s, A = E D E + D D+E D+E (2)

This gives us another way of showing (1). By the CAPM, A = Rf + A (R M Rf ) R But we know that A is just a weighted average of E and D . Substituting in: A = Rf + R E D M Rf ) E + D ( R D+E D+E
E R D+E f

Expanding out this equation: (Note that Rf = A = R

D R ) D+E f

E M Rf )) + D (Rf + D (R M Rf )) (R f + E ( R D+E D+E E D = RE + RD D+E D+E

Which is just equation (1). Thus there are two equivalent ways of calculating the WACC. A 1. From E and D , calculate RE and RD using the CAPM. Then calculate R by (1). A using the CAPM. 2. From E and D , calculate A using (2). Then calculate R We have just shown that these two methods are guaranteed to give you the same answer. 5