Project-speciific discount rate

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    wendy2001
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    Hello, Sir Thank you for your wonderful lectures.
    Example 2 of Chapter 21 in your lecture notes,the project is entirely financed from equity(so no gearing risk), we use CAPM to get the cost of equity.If the project is financed by X% of debt and Y% of equity,for example,Q54(b)FAQ in BPP revision kit, ungear equity Beta of a competitor and regear asset Beta for the new project, then use CAPM. Is the beta in CAPM only include systematic risk? It doesn’t make sense to me the regeared Beta is used in CAPM formula. Please advise.


    Avatar of Vipin
    Vipin
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    equity beta includes systematic risk and financial risk.

    when degearing you can get asset beta for the company which would be same for all industry of same kind.

    once u get beta asset, u can regear to include financial risk of the company you wish to calculate.

    CAPM considers only systematic risk.
    systematic risk is fo two fold.
    1)bussiness risk
    2)financial risk.

    by taking the ratio of equity and capital , we incorporate financial risk.
    more debt the company has more is the financial risk.

    2 different company produces same good, but their captial structure may be different then their financial risk is different . at the same time, their bussiness risk is same.
    suppose say , pepsi cola co amd coca cola co.

    their asset beta is same ie, their bussiness risk is same. but then may follow different capital structure so their equity beta is different.

    suppose , say, u r given the equity beta of pepsi cola and ask to find equity beat of coca cola co.
    first, u have to degear it and u will get asset beta, then regear it using this asset beta to get equity beta of coca cola.


    Avatar of johnmoffat
    John Moffat
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    What Vipin is saying is correct :-)


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    wendy2001
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    So the beta in CAPM can be understood as equity beta?


    Avatar of johnmoffat
    John Moffat
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    That is not what Vipin said.

    The beta of a share is the equity beta. It is usually the beta of share that is given.

    However, as Vipin said, any gearing in the company will make the share more risky – so a higher equity beta.

    If we want to know the risk of the actual business (i.e. ignoring any gearing) then we look at the asset beta.


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    wendy2001
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    Thank you, Sir and Vipin.


    Avatar of johnmoffat
    John Moffat
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    You are welcome :-)

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