Principles of Managerial Finance

CHAPTER 10 Risk and Refinements in Capital Budgeting 435

project falling above the SML would have a positive NPV, and any project falling

below the SML would have a negative NPV.^4

EXAMPLE Two projects, L and R, are shown in Figure 10.2. Project L has a beta, bL, and

generates an internal rate of return, IRRL. The required return for a project with

risk bLis kL. Because project L generates a return greater than that required

(IRRLkL), project L is acceptable. Project L will have a positive NPV when its

cash inflows are discounted at its required return, kL. Project R, on the other

hand, generates an IRR below that required for its risk, bR(IRRRkR). This proj-

ect will have a negative NPV when its cash inflows are discounted at its required

return, kR. Project R should be rejected.

Applying RADRs

Because the CAPM is based on an assumed efficient market, which doesnotexist

for real corporate (nonfinancial) assets such as plant and equipment, the CAPM is

not directly applicable in making capital budgeting decisions. Financial managers

therefore assess thetotal riskof a project and use it to determine the risk-adjusted

discount rate (RADR), which can be used in Equation 10.2 to find the NPV.

In order not to damage its market value, the firm must use the correct dis-

count rate to evaluate a project. If a firm discounts a risky project’s cash inflows

at too low a rate and accepts the project, the firm’s market price may drop as

investors recognize that the firm itself has become more risky. On the other hand,

Reqired Rate of Return (%)

IRRL

kL

km

kR

IRRR

RF

R

L

Acceptance

(IRRproject > kproject; NPV > $0) SML

kproject = RF +

[bproject × (km – RF)]

Rejection

(IRRproject < kproject; NPV < $0)

bR bmarket = 1 bL

Project Risk (bproject)

0

FIGURE 10.2

CAPM and SML
CAPM and SML in capital
budgeting decision making

4. As noted earlier, whenever the IRR is above the cost of capital or required return (IRRk), the NPV is positive,
   and whenever the IRR is below the cost of capital or required return (IRRk), the NPV is negative. Because by def-
   inition the IRR is the discount rate that causes NPV to equal zero and the IRR and NPV always agree on
   accept–reject decisions, the relationship noted in Figure 10.2 logically follows.