In terms of npv any chapter 10 risk and refinements

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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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