The Capital Asset Pricing Model (CAPM) for Determining Discount rate in Project Appraisal

 

Introduction; The Capital Asset Pricing Model (CAPM) concept was based on Harry Markowitz's portfolio theory, which dates back to 1952, the portfolio theory suggested that by diversifying their investments, investors can optimize their expected returns at a specific level of risk (Sullivan, 2006). However, there was a lack of models or theories at that time that could determine the cost of capital or discount rate of a project. Later, in the early 1960s, four economists (namely Lintner J, Mossin J, Sharpe W, and Treynor J) developed models that had similarities to each other and described the relationship between asset return and risk (Fama & French, 2004).

CAPM for Determining Discount rate in Project Appraisal; To determine the appropriate discount rate for project appraisal, it is common practice to apply the Capital Asset Pricing Model (CAPM) when the risks associated with the project and the company differ (Nhleko & Musingwini, 2016). One important step in involves gathering information about other companies operating in the same industry as the project in question exposure to the project under consideration (Fama & French, 2004). The next step in estimating the projected rate of return for the project is to use a formula., which is presented below: 

After the expected rate of return (Rf) is determined, the CAPM integrate numbers of other strategies and technique in finance landscape to determine discount rate of project invested. Some of those techniques are Net Present Value (NPV), Interest Rate of Return (IRR), and Discounted Payback which each has provided investors with decision making opportunities (Fajasy, 2022).

        i.            Net Present Value (NPV), involves calculating a rate using CAPM and determining whether the resulting NPV is positive that indicates that the investment is worthwhile.

      ii.            Internal Rate of Return (IRR), if the IRR is greater than the one calculated using CAPM then the investment may be worth considering.

    iii.           Discounted Payback Period, involves comparing the payback calculated using CAPM to the payback from the discounted payback period. If the project's payback falls within the discounted payback period, it may be a worthwhile investment.

Doubts on Usage of CAPM to Determine the Discount Rate; Although the CAPM has made a valuable contribution to determining discount rates for project appraisal, there are certain limitations that may cast doubt on its usefulness of CAPM as below;

A major drawback of the CAPM is that it relies on certain assumptions, such as the efficient market hypothesis, which may not hold true in all situations. This could potentially impact the accuracy and reliability of the model's results, leading to uncertainties in project appraisal (Fajasy, 2022).

Another limitation of the CAPM is its narrow focus on market risk and assumption of equal access to information, this approach can lead to a limited understanding of investment value, as it ignores factors such as industry-specific risks, geopolitical events, or regulatory changes that could significantly impact investment returns. Therefore, relying solely on the CAPM for project appraisal may not provide a complete picture of the investment's potential risks and rewards.

CAPM has limitations when it comes to project appraisal as it relies on historical data which may not always be a reliable indicator of future performance, unforeseen events, changes in market conditions, and technological advancements can all make historical data irrelevant (Diksha, 2022).

Identifying the project's proxy beta is another limitation; To evaluate an investment using the CAPM companies must obtain a beta that precisely represents the project or investment, but determining project's proxy beta that is dependable can be challenging and could impact the accuracy of the result. Thoroughly assessing the factors that affect the proxy beta, such as market trends, the competitive environment, and the unique qualities of the project, is essential to establish a proxy beta that is as precise and trustworthy as feasible (Sharma & Vaidya, 2022).

Model ignored other business risk and consider systematic risk only; The CAPM operates under the assumption that systematic risk is the primary factor that determines a security's required rate of return, but the model ignore other factors that can also impact a security's return, such as its sensitivity to inflation, dividend payouts, and other variables (CFA Journal, 2023).

Conclusion; The Capital Asset Pricing Model (CAPM) provides valuable insight into the various factors that influence the value of assets. By highlighting the importance of diversification in investors' asset ownership, the model suggests that although diversifying may lead to lower expected returns, it can result in higher prices

References

CFA Journal. (2023). How to use CAPM for investment appraisal? (3 Methods). Retrieved from CFA Journal: https://www.cfajournal.org/use-capm-investment-appraisal/

Diksha, P. (2022). capm: Assumptions and Limitations: Securities, Financial and Economics. Retrieved from Economics Discussion: https://www.economicsdiscussion.net/portfolio-management/capm/capm-assumptions-and-limitations-securities-financial-economics/29904#

Fajasy. (2022, September). How to Calculate and Interpret the Capital Asset Pricing Model (CAPM). Retrieved from StableBread: https://stablebread.com/how-to-calculate-and-interpret-the-capital-asset-pricing-model-capm/#:~:text=As%20a%20form%20of%20systematic,expected%20returns%20than%20the%20market.

Fama, E., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, Volume 18, Number 3; pp 25-46.

Nhleko, S., & Musingwini, C. (2016). Estimating cost of equity in project discount rates: Comparison of the Capital Asset Pricing Model and Gordon's Wealth Growth Model. Journal of the Southern African Institute of Mining and Metallurgy, Volume 116(3):215-220.

Sharma, A., & Vaidya, D. (2022). Capital Asset Pricing Model. Retrieved from WallStreetMojo: https://www.wallstreetmojo.com/capital-asset-pricing-model-capm/

Sullivan, E. (2006). A Brief History of the Capital Asset Pricing Model. APUBEF Proceeding - Fall 2006 (pp. 207-210). Lebanon: Valley College.

Unifinn. (2023). CAPM Advantages and Disadvantages; Capital Asset Pricing Model formula. Retrieved from UNIFINN: https://unifinn.com/capm-advantages-and-disadvantages/

Zeng, Y., & Klabjan, D. (2018). Portfolio optimization for American options. Journal of Computational Finance, Volume 22, Number 3; pp 37-64.