Principles of Managerial Finance

434 PART 3 Long-Term Investment Decisions

Therisk-adjusted discount rate (RADR)is the rate of return that must be

earned on a given project to compensate the firm’s owners adequately—that is, to

maintain or improve the firm’s share price. The higher the risk of a project, the

higher the RADR, and therefore the lower the net present value for a given stream

of cash inflows. Because the logic underlying the use of RADRs is closely linked to

the capital asset pricing model (CAPM) developed in Chapter 5, here we review

CAPM and discuss its use in finding RADRs.

Review of CAPM

In Chapter 5, the capital asset pricing model (CAPM)was used to link the rele-

vantrisk and return for all assets traded in efficient markets.In the development

of the CAPM, the total riskof an asset was defined as

Total riskNondiversifiable riskDiversifiable risk (10.3)

For assets traded in an efficient market, the diversifiable risk,which results from

uncontrollable or random events, can be eliminated through diversification. The

relevant risk is therefore the nondiversifiable risk—the risk for which owners of

these assets are rewarded. Nondiversifiable risk for securities is commonly mea-

sured by using beta,which is an index of the degree of movement of an asset’s

return in response to a change in the market return.

Using beta, bj, to measure the relevant risk of any asset j,the CAPM is

kjRF[bj(kmRF)] (10.4)

where

kjrequired return on asset j

RFrisk-free rate of return

bjbeta coefficient for asset j

kmreturn on the market portfolio of assets

In Chapter 5, we demonstrated that the required return on any asset could be

determined by substituting values of RF, bj, and kminto the CAPM—Equation

10.4. Any security that is expected to earn in excess of its required return would

be acceptable, and those that are expected to earn an inferior return would be

rejected.

Using CAPM to Find RADRs

If we assume for a moment that real corporate assets such as computers, machine

tools, and special-purpose machinery are traded in efficient markets, the CAPM

can be redefined as noted in Equation 10.5:

kproject jRF[bproject j(kmRF)] (10.5)

The security market line(SML)—the graphical depiction of the CAPM—is shown

for Equation 10.5 in Figure 10.2. Any project having an IRR above the SML

would be acceptable, because its IRR would exceed the required return, kproject;

any project with an IRR below kprojectwould be rejected. In terms of NPV, any

risk-adjusted discount rate
(RADR)
The rate of return that must be
earned on a given project to
compensate the firm’s owners
adequately—that is, to maintain
or improve the firm’s share price.