Notes for the Divisional Manager on the Capital Asset Pricing Model (CAPM) and Investment Appraisal

Introduction to the Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a way of calculating the expected return on an investment, based on its risk in relation to the overall market. While it is commonly used to evaluate the return on stocks, the concept can also be applied to large projects like the one your division is considering.

CAPM is based on the idea that investors demand a higher return for taking on more risk. So, for any project, the return should reflect both the general market risk and the specific risk of the project itself.

Key Terms to Know:

• Risk-Free Rate: The return on an investment that is considered “risk-free,” like government bonds. This is usually the starting point in the CAPM calculation.
• Market Return: The average return expected from the overall market.
• Beta: A measure of how much the project’s or company’s returns are expected to move in relation to the market. If the project is riskier than the market, its beta will be higher than 1. If it’s less risky, the beta will be lower.

The formula for CAPM is:

Expected Return=Risk-Free Rate+β× (Market Return−Risk-Free Rate)

Why the Head Office Used the CAPM to Discount the Figures

The reason the head office is using CAPM to discount the cash flows for the project is that it helps determine the appropriate rate of return that reflects the project’s risk. Here’s why they might have used this method:

1. Risk Consideration: The CAPM takes into account the risk of the project compared to the market. Even though inflation might be low, the project could still carry significant risk due to factors such as changes in market demand, competition, or operational difficulties. The CAPM ensures that these risks are accounted for when assessing the project’s potential return.
2. Discounting Cash Flows: Discounting is a standard technique in finance to account for the time value of money. Cash received in the future is worth less than cash received today because of inflation, uncertainty, and the opportunity cost of capital. By applying a discount rate (calculated using CAPM), the head office is adjusting future cash flows to their present value, ensuring a fair evaluation.

Payback vs. Discounted Cash Flow (DCF)

You mentioned that the divisional team typically uses the payback method for smaller projects. This method calculates how quickly the initial investment is recouped based on the project’s cash flows. However, while payback is simple and easy to use, it has some limitations:

1. Ignores Time Value of Money: Payback does not account for the fact that cash flows in the future are less valuable than cash flows today. The discounted cash flow (DCF) method, which uses the CAPM to calculate the appropriate discount rate, accounts for this by adjusting future cash flows.
2. Ignores Cash Flows After Payback: Payback only looks at how quickly the project breaks even and ignores the potential benefits (or costs) that come after the payback period. A project that has a long life and significant cash flows after the payback period could be more profitable, even if the payback period is longer than five years.

Why DCF (with CAPM) is Preferred:
The head office is likely using DCF to get a more accurate picture of the project’s true value. This method looks at all the cash flows, both before and after the payback period, and discounts them to reflect their true worth in today’s terms.

Key Points to Emphasize for the Meeting

1. Use of the Discount Rate:
   • The head office is likely using CAPM to calculate a rate that reflects both the risk-free return and the project’s specific risk (via the beta). This ensures that the project is evaluated fairly in comparison to other investment opportunities, considering the risk involved.
2. Payback Isn’t Enough:
   • While payback is a helpful, quick tool, it doesn’t give the full picture of a project’s profitability. The DCF method using CAPM provides a better long-term view by factoring in the time value of money and future cash flows.
3. Argument for Using CAPM:
   • The CAPM approach is an industry-standard method for evaluating projects with risks. It aligns with the company’s overall strategy to ensure resources are allocated to projects that offer a return that justifies the risk.
   • Even if inflation is low, there are still other factors, such as market fluctuations, competition, and the project’s specific risks, which make the CAPM a more accurate way of valuing future cash flows.

Summary and Final Thoughts

You’re right to be passionate about the project, but it’s essential to understand that financial evaluations are based on facts and methods that account for both potential returns and risks. While the payback method works for smaller projects, the use of CAPM to discount cash flows is standard practice for larger projects, as it provides a more accurate, risk-adjusted evaluation.

When discussing the project at the meeting, it’s important to recognize that the head office’s approach isn’t a “ploy” to stop the project; rather, it’s a careful consideration of the project’s long-term value based on all the available information.

Feel free to ask for further clarifications if necessary.