ApplyingTheCAPMToCapitalBudgeting

# ApplyingTheCAPMToCapitalBudgeting - Applying the CAPM to...

This preview shows pages 1–2. Sign up to view the full content.

This preview has intentionally blurred sections. Sign up to view the full version.

View Full Document
This is the end of the preview. Sign up to access the rest of the document.

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 firm’s existing projects. Assume that the CAPM is true. Then the cost of capital of the firm is r = R f + β ( ¯ R M- R f ) where β is Cov( R, R M ) /σ 2 M , calculated for returns on the firm’s 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:...
View Full Document

{[ snackBarMessage ]}

### Page1 / 3

ApplyingTheCAPMToCapitalBudgeting - Applying the CAPM to...

This preview shows document pages 1 - 2. Sign up to view the full document.

View Full Document
Ask a homework question - tutors are online