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**Unformatted text preview: **ed the required return, kproject;
any project with an IRR below kproject would be rejected. In terms of NPV, any CHAPTER 10 Risk and Refinements in Capital Budgeting 435 CAPM and SML
CAPM and SML in capital
budgeting decision making Reqired Rate of Return (%) FIGURE 10.2
Acceptance
(IRRproject > kproject ; NPV > $0)
L IRRL
kL
km
kR SML kproject = RF +
[bproject × (km – RF)] Rejection
(IRRproject < kproject ; NPV < $0)
R IRRR RF 0 bR bmarket = 1 bL Project Risk (bproject) project falling above the SML would have a positive NPV, and any project falling
below the SML would have a negative NPV.4
EXAMPLE Two projects, L and R, are shown in Figure 10.2. Project L has a beta, bL, and
generates an internal rate of return, IRRL. The required return for a project with
risk bL is kL. Because project L generates a return greater than that required
(IRRL kL), project L is acceptable. Project L will have a positive NPV when its
cash inflows are discounted at its required return, kL. Project R, on the other
hand, generates an IRR below that required for its risk, bR (IRRR kR). This project will have a negative NPV when its cash inflows are discounted at its required
return, kR. Project R should be rejected. Applying RADRs
Because the CAPM is based on an assumed efficient market, which does not exist
for real corporate (nonfinancial) assets such as plant and equipment, the CAPM is
not directly applicable in making capital budgeting decisions. Financial managers
therefore assess the total risk of a project and use it to determine the risk-adjusted
discount rate (RADR), which can be used in Equation 10.2 to find the NPV.
In order not to damage its market value, the firm must use the correct discount rate to evaluate a project. If a firm discounts a risky project’s cash inflows
at too low a rate and accepts the project, the firm’s market price may drop as
investors recognize that the firm itself has become more risky. On the other hand, 4. As noted earlier, whenever the IRR is above the cost of capital or required return (IRR k), the NPV is positive,
and w...

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