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CAPM and MM Combined – ACCA Financial Management (FM)

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  2. As I understood CAPM can be used as the project discounted rate if project is to be equity financed. And if the project is to be financed both debt and equity than shareholders req.return will need discount rate as WACC, combined with cost of debt. Also I understand from this lecture that CAPM does not assume that the firm is financed entirely from equity. Question is, to use CAPM does specific project needs to be financed by equity while company has gearing in general? Or project can be financed with equity and debt to use CAPM and than first statement is not true? And last, if using WACC can cost of equity be calculated as formula D1/Po + g OR CAPM witch would mean we can use CAPM in WACC? doesn’t matter would we be asked for this in exam – for my information. thank you in advance!

    • How we calculate the cost of equity depends on the information available in the question. If we are given beta factors then we use CAPM (and it is the equity beta that determines the cost of equity, which may been using the asset beta formula to arrive at it). If, instead, w are given information about future expected dividends then we use the growth formula. (Please ask any more questions about this in the Ask the Tutor Forum rather than as a comment on a lecture 馃檪 )

  5. Hi Sir,

    Thank you for the lecture. I noted that we would assume Debt Beta is risk free in the exam and can you please explain why it would be 0%? Based on examples from previous chapter on CAPM, the risk-free rate is never really 0% but can be 5%, 8% etc. is this different for debt?

    Thanks and Regards,
    Tim

    • You are confusing two things. The risk free rate is the rate of interest on a risk-free investment.
      Beta measures the level of risk and if something is risk-free then it has a beta of 0.

      In theory debt is risk free and therefore has a beta of 0. (In real life, debt is risky but is low risk and therefore has a low beta. When using the asset beta formula we always assume that the beat of debt is zero.

  6. Hi Sir, in the previous chapter beta was defined as a measure of systematic risk in proportion to the market. Here beta is the total risk in proportion to the market. Which is right?

  7. Hi sir, for example 2, we are calculating the cost of equity for the project alone and it only has systematic risk since its all equity. So why do we need to take into account the gearing of the company, unless we were going to use the WACC for the project’s appraisal?

    • Correction : Unless we were going to use the NEW cost of equity of the company as a whole to calculate the NEW WACC for the project’s appraisal?

      • The project specific cost of equity is the cost of equity relevant for the project taking into account the gearing existing in the company and the risk of the project. We would use this to calculate a WACC to apply to the project, but that part of not examinable until Paper AFM (and in fact there is a different approach that can be used as you will see when you come to Paper AFM. In Paper FM you can only be asked to calculate the project specific cost of equity as shown in this example.

  8. Hi sir, does it mean that in the last chapter we were using the Asset Beta to calculate the cost of equity considering there was no gearing ?

  9. Hello Sir, thank you for the great explanation.

    However I have a little confusion, in example 2 we said the new project will have the same gearing as the firm, but then we used CAPM to get the required return
    even though CAPM assumes firm is financed entirely from equity. How is it right to use CAPM in this case?

    • CAPM does. not assume that the firm is financed entirely from equity. CAPM gives us the cost of equity for any equity beta. The equity beta measures the risk of the share – the risk of the business together with the risk due to the fearing.

  10. Hello Sir. Thanks for the amazing lectures. In example 2, we have been asked to calculate only the cost of Equity for the project. In the exams however, can we be asked to calculate the total cost of capital (cost of equity + cost of debt- using WACC) for that specific project? Thank you

    • Because it is not relevant and (as is the case in the exam) it is there to check that you know it is not relevant. 1.48 is the beta for shares in an oil company. The investment is building ships which has a different level of risk.

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