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CAPM in capital budgeting

2 types of risks considered in establishing interest rate:

- Business risk

- Financial risk

Business risk pertains to how the industry as a whole is perceived. An industry like

Entertainment will need to pay higher interest rates, because of the inherent

instability of the markets, while healthcare organisations are generally perceived to

have stable earnings, and are generally lent loans at lower interest rates.

Financial risk is evaluated using CAPM.

rE= rf + βE* ( rM-rf )

Risk free rate: rf  is approximated to be 90-day treasury bill rate. Other low risk

investments such as Govt. Insurance Trust Fund, can also be used.

Market rate: Market return can be measured by the standard followed by the

standard market industries or companies from the same industry. Take the example

of a company in the US, we would use the S&P 500’s returns.

Beta of a stock: It is more complicated to calculate β. β is the measure of 

systematic risk. If the company is listed, β can be obtained from published sources.

It is basically calcuted based on stock price changes. If it is not listed, then β can be

calculated by taking an average of historical data on interest rates.

CAPM is generally used to value the returns expected by equity shareholders.

However, it can also be used to determine the required return on debt, or cost of 

debt capital.

CAPM for debt is

rD= rf + βD* ( rM-rf )

Risk free rate is same as for equity calculations. Most common measure being thegovt T 90 Bills. Market rate for debt is again the weighted average of rates in the

market.

βD unlike for equity is not frequently calculated or published. The market rate for

debt relies on market rating agencies like S&Ps or CRISIL to provide measures of 

risk. And ratings are discrete, say AAA, AA, BBB etc, unlike continuous values of βE.

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After comparing the returns using the two equations, we can have a comparative

analysis for the two.

In addition to these factors, some other decisions which can affect the company’s

decision could be:

- The company wants to retain ownership to a large extent, and might not

want to diversify it by raising capital through equity.

- Another factor could be time. Raising equity can take longer time, because of 

the regulatory processes. Going through the loan market will be speedier.

Moreover, raising equity involves more cost as compared to taking a loanfrom a bank.

- Capital market conditions also play a major factor in determining which

source of capital must the company go for.

- Infact, interest is tax deductible as it is an expense that is deducted before

tax is paid. Hence, if the company has a low leverage, debt would be a better

option. However, at a point a company would be indifferent to taking debt or

equity.