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Unformatted text preview: H AAS S CHOOL OF B USINESS U NIVERSITY OF C ALIFORNIA AT B ERKELEY UGBA 103 A VINASH V ERMA CAPM AND C APITAL B UDGETING 1. CAPM says that in equilibrium, only the systematic risk of a security is priced in the market in the sense that only the systematic undiversifiable risk of a security is factored into the returns on a security that participants in market expect. The reason why the unsystematic or the diversifiable is not factored in the return that participants in market expect is that participants in market hold the market portfolio, and when securities are held as a part of a diversified portfolio, the diversifiable portion of their risk is diversified away. When a publicly traded firm considers a capital budgeting project, its management takes into account the fact that the shareholders of the firm hold its shares as a part of a large diversified portfolio. These shareholders will not care about the diversifiable part of the risk of the cash flows of the project because the diversifiable portion of the risk of cash flows is diversified away (or averaged out) in a large portfolio. Therefore, the risk-adjusted discount rate for a given cash flow will depend not on the total risk of the cash flows (as measured by their standard deviation) but on the systematic risk of that cash flow as measured by its beta with the market portfolio. Algebraically: ( 29 f M M CF f R E R Rate Discount- + = , 2. While in principle we would like to consider the systematic risk of each individual cash flow associated with a project, in practice the task is very difficult. Therefore, in practice, it is commonly assumed that all cash flows that a given project is going to generate have the same time and risk characteristics, and accordingly focus on estimating MARKET PROJECT , , or more concisely PROJECT , 1 the beta between the returns on the project and those on the market. In other words, we shall assume that there is a single discount rate for all cash flows of a project, and that it is given by: ( 29 f M PROJECT f R E R Rate Discount- + = 3. The key problem in applying the NPV rule to Capital Budgeting, that of factoring the risk into the discount rate, thus boils down to estimation of the PROJECT . The shareholders are concerned only with the systematic undiversifiable risk, and if a project has high systematic risk as measured by its PROJECT , then shareholders will expect the management to add a high premium to the risk free rate to arrive at the appropriate discount rate for that project. Once again, management assumes that the shareholders of the firm, like all other investors, hold a well-diversified portfolio. As a result, any diversifiable risk that the cash flows of the project have will be diversified away, and only the systematic risk of the cash flows will need be factored into the discount rate....
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- Summer '07