Because the logic underlying the use of radrs is

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Unformatted text preview: gher the RADR, and therefore the lower the net present value for a given stream of cash inflows. Because the logic underlying the use of RADRs is closely linked to the capital asset pricing model (CAPM) developed in Chapter 5, here we review CAPM and discuss its use in finding RADRs. Review of CAPM In Chapter 5, the capital asset pricing model (CAPM) was used to link the relevant risk and return for all assets traded in efficient markets. In the development of the CAPM, the total risk of an asset was defined as Total risk Nondiversifiable risk Diversifiable risk (10.3) For assets traded in an efficient market, the diversifiable risk, which results from uncontrollable or random events, can be eliminated through diversification. The relevant risk is therefore the nondiversifiable risk—the risk for which owners of these assets are rewarded. Nondiversifiable risk for securities is commonly measured by using beta, which is an index of the degree of movement of an asset’s return in response to a change in the market return. Using beta, bj, to measure the relevant risk of any asset j, the CAPM is kj RF [bj (km RF)] (10.4) where kj RF bj km required return on asset j risk-free rate of return beta coefficient for asset j return on the market portfolio of assets In Chapter 5, we demonstrated that the required return on any asset could be determined by substituting values of RF, bj, and km into the CAPM—Equation 10.4. Any security that is expected to earn in excess of its required return would be acceptable, and those that are expected to earn an inferior return would be rejected. Using CAPM to Find RADRs If we assume for a moment that real corporate assets such as computers, machine tools, and special-purpose machinery are traded in efficient markets, the CAPM can be redefined as noted in Equation 10.5: kproject j RF [bproject j (km RF)] (10.5) The security market line (SML)—the graphical depiction of the CAPM—is shown for Equation 10.5 in Figure 10.2. Any project having an IRR above the SML would be acceptable, because its IRR would exce...
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