Time value of money is a critical consideration in financial and investment decisions.
Discounting, or the calculation of present value, which is inversely related to
compounding is used to evaluate future cash associated with capital budgeting projects.Other Long-range capital decision tool is capital asset pricing model (CAPM) is often
used to estimate a firm cost of equity financing. A security consists of two components-
diversifiable risk and non-diversifiable risk. Diversifiable risk, sometimes-controllable
risk or unsystematic risk represents the portion of the security’s risk that can be
controlled through diversification.This type of risk is unique to a given security. Business, liquidity, and default risks fall
into this category. Non –diversifiable risk sometimes referred to as non-controllable risk
or systematic risk, result from forces outside of the firm’s control. Therefore is not
unique to the given security. Purchasing power, interest rate, and market risks fall into
this category.Non-diversifiable risk is assessed relative to the risk of a diversified portfolio of
securities, or the market portfolio. This type of risk is measured by the beta coefficient.
The CAPM relates the risk measured by beta to the level of expected or required rate of
return in a security. The model also called the security market line (SML)The capital asset pricing model (CAPM) can be used to determine the appropriate cost
of capital as the rate to discount future cash flow. The IRR method uses the cost of
capital as the cut off rate.The required rate of return or cost of capital according to the CAPM, or security market
line (SML) is equal to the risk free rate of return (rf) plus a risk premium equal to the
firm’s beta coefficient (b) ties the market risk premium (rm-rf): rj + rf+b(rm-rf)A project has the following projected cash flows:
Year 0 Year 1 Year 2 Year 3
Le ( 4000 ) Le3000 Le2000 Le 1000
The estimated beta for the project is 1.5. the market return is 12%, and the risk free rate is 6%.
Then the cost of capital or required rate of return for the firm is