Earlier chapters on capital budgeting assumed that projects generate riskless cash flows. The appropriate discount rate in that case is the riskless interest rate. Of course, most cash flows from real world capital budgeting projects are risky. This chapter discusses the discount rate when cash flows are risky.
A firm with excess cash can either pay a dividend or make a capital expenditure. Because stockholders can reinvest the dividend in risky financial assets, the expected return on a capital budgeting project should be at least as great as the expected return on a financial asset of comparable risk.
The expected return on any asset is dependent upon its beta. Thus, we showed how to estimate the beta of a stock. The appropriate procedure employs regression analysis on historical returns.
We considered the case of a project whose beta risk was equal to that of the firm. If the firm is unlevered, the discount rate on the project is equal to:
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where RM is the expected return on the market portfolio and RF is the risk-free rate. In words, the discount rate on the project is equal to the CAPM's estimate of the expected return on the security.
If the project's beta differs from that of the firm, the discount rate should be based on the project's beta. The project's beta can generally be estimated by determining the average beta of the project's industry.
The beta of a company is a function of a number of factors. Perhaps the three most important are:
Cyclicality of revenues
Operating leverage
Financial leverage
Sometimes one cannot use the average beta of the project's industry as an estimate of the beta of the project. For example, a new project may not fall neatly into any existing industry. In this case, one can estimate the project's beta by considering the project's cyclicality of revenues and its operating leverage. This approach is qualitative in nature.
If a firm uses debt, the discount rate to use is the RWACC. In order to calculate RWACC, the cost of equity and the cost of debt applicable to a project must be estimated. If the project is similar to the firm, the cost of equity can be estimated using the SML for the firm's equity. Conceptually, a dividend growth model could be used as well, though it is likely to be far less accurate in practice.
