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Unformatted text preview: Applying the CAPM to Capital Budgeting 1 Previously we calculated net present value given a discount rate r , without dis- cussing where r came from. One major reason why we are interested in the CAPM is it tells us what r should be. Result Consider a firm that has no debt. Consider a project in the same line of business as the firms existing projects. Assume that the CAPM is true. Then the cost of capital of the firm is r = R f + ( R M- R f ) where is Cov( R, R M ) / 2 M , calculated for returns on the firms equity. In other words, when deciding to take a project with cash flow C today and expected future cash flows C 1 , C 2 , . . . , the firm should calculate the NPV of the project as: NPV = C + X t =1 C t (1 + r ) t . so r is the discount rate for the future payoffs. To maximize firm value, the firm should accept the project if NPV > 0, otherwise the firm should reject the project. This result 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 payoff case:...
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