Capital Asset Pricing Model (CAPM) and Capital Budgeting

Sometimes it is difficult to estimate the return expected by

the company’s equity providers, which makes the
estimation of the rate of discount suitable to the project
impossible. A new company has no way of knowing the
returns that equity providers expect and what its cost of
capital is going to be. In such cases, CAPM is useful tool.
The application of the CAPM in finding the rate of discount
suitable for a project is as follows:
1. Obtain a sample of betas of firms engaged in the
same line of business as the proposed project.
Betas of firms engaged in the same line of activity and
are comparable in size and scale should be obtained.
2. Obtain assets beta from the equity betas:
Just as the equity has a beta, assets also can be
assigned a beta value and it can be found given the
equity beta, debt-equity ratio an the tax rate.
The securities - equity and debt issued by a company; the
beta of the portfolio (βp) is equal to the beta of the
assets (β A) of the company.
βp = β A Eqn. 1
The beta of the portfolio can be expressed as the weighted
average of the betas of the debt and equity issued by the
company. That is,
βp = β E [E / (E + D)] + β D [( D / (E + D)] Eqn. 2
Since βp = β A ,
β A = β E [E / (E + D)] + β D [( D / (E + D)]
So, β E = β A + (β A - β D ) x D / E
If the beta of the debt is assumed to be zero ( this means
that debt is considered to be risk-free), we get
βE = βA + βA x D = βA 1 + D Eqn. 3
E E
or β A = β E / 1 + D or β E = β A 1 + D ( 1 –T) for tax shield
Eqn. 4 E E of debt Eqn. 5
And, β A = βE Eqn. 6
1 + D ( 1 –T )
E

Once the assets betas of all the firms are calculated, the
average β A should be calculated.
3. Calculate the average equity beta for the proposed
project from the asset beta.
The equity beta can be calculated using equation 5
4. Apply the CAPM to find out the return required on
the equity:
Re = Rf + ( Rm – Rf ) β E
where Re = Return required on equity
Rf = Risk-free rate
Rm = Return on market folio
β E = Equity beta
 5. Find the weighted Average cost of capital for the project.
WACC = WeKe + WdKd ( 1-T )
We = Weight of equity in the capital
Wd = Weight of debt in the capital
Ke = cost of equity
Kd = Cost of debt
T = Tax rate
Exercise: Magnum Limited is considering a cement project for
which it proposes to employ a debt-equity ratio of 2:1.
Its pre-tax cost of debt is 16% and the tax rate is 30%.
There are three firms A, B, and C engaged in cement
manufacture. Their tax rate is 30%. Their equity betas and
debt-equity ratios are as under:
A 1.25 2.25
B 1.15 2.00
C 1.10 2.10
The risk free is 12% and the expected return on the market
portfolio is 17%. Find out the required the rate of return.
Solution:
1. Calculation of assets betas
From the given information and equation 6, asset betas are:
A : 0.485
B : 0.479
C : 0.445
The average is 0.47 ≈ 0.50
2. Calculation of equity betas
Using equation 5,
The equity beta of Magnum : 0.50 { 1 + 2.0 ( 1- 0.30)}=1.20
3. Calculation of expected rate of return ( cost of equity)
Ke = Rf + β ( Rm – Rf) = 0.12 + 1.20 ( 0.17 – 0.12)
= 0.18 or 18%
4. Calculation of WACC –(required rate of return)
WACC = WeKe + WdKd ( 1-T )
= 1/3 x18 + 2/3 x 16 ( 1 - 0.30)
= 13.46%
Environmental Appraisal of Projects
1. Factors that can induce the corporates to behave in a
more environmental friendly manner:
 Pollution control regulation
 Consumer pressure
 Pressures from the local people and
 Pressure from the investors
2 What is Environmental Pollution?
The environment of man consists of everything that
is outside him. It is earth, all things on it,
surrounding it and within it. It consists of living and
non-living components. The life component includes
the plants, animals and micro-organisms. The
non-life components consists of the land, water, air,
clouds, sunshine, etc.
In relation to a project, “environment can be defined
as the surrounding area within which the life and
non-life components are subject to the influence of
 of the project” According the Environmental ( Protection )
Act, 1986, ‘ environment’ includes water, air, and land and
the interrelationship which exists among and between water,
air and human beings, other living creatures, plants, micro-
organisms and property. The definition includes the
interactions between the non-life components and their
interactions with the living creatures also.
Sources of Pollution:
Air and water are the major perpetrators of pollution.
Liquid, solid or gaseous fuel can pollute air in the form of
smoke. Road vehicles, air crafts, ships and rail engines – all
contribute to pollution of air.
Water pollution is more complex. There are many ways in
which water gets polluted :
a) Dumping of industrial affluents on the ground
b) Pesticides used for agriculture
c) Fertilizers
d) Waste materials dumped on the ground reach rivers
 e) Industrial wastes discharged directly into sewage canals.
f) Discharge of sewage from communities into rivers and
lakes.
Pollutants released by various industries
 Tanneries
 Textile industry
 Distilleries
 Fertilizers
 Steel mills
 Oil refineries
 Drugs and pharmaceuticals
 Sugar
 Chemicals – Dyes and dye intermediates
Methods of Effluent Treatment
Air Pollution
Mechanical separation
Elecrostatic Precipitation
Filtering
Scrubbing
Treatment water pollutants
 Primary treatment
 Secondary treatment
 Tertiary treatment

Environmental Laws in India

The Water ( Prevention and Control of Pollution) Act, 1971
The Air ( Prevention and Control of Pollution) Act, 1981
The Environmental ( Protection ) Act, 1986

Environmental Impact Assessment of Projects

A study of the environmental impact is called
Environmental Impact Assessment (EIA) and a
statement of the impact is referred to as Environmental
Impact Statement(EIS). EIS is defined as the the
identification, prediction, interpretation and communication
of information about the impact of a project on man’s
health and well being. It is the study of the changes in the
socio-economic and bio-physical attributes of the
environment, which may result from the project.
EIS contains the following:
i. Description of the project, purpose, and technical details
ii. Effect on the land use plan, policies and controls in
the surrounding areas.
iii. Impact of the project on each component of the
environment.
iv. Possible alternative projects that do not cause adverse
effects as foreseen in the present project.
v. Proposed measures to contain the adverse effects of the
projects on the environment.
vi. Amount of unavoidable pollution in spite of taking all
possible measures to avoid the undesirable impact on
the environment.
vii. An evaluation of the commercial and social desirability
of the project in comparison with the pollution caused.
 viii. Amounts of resources that have to be committed
irretrievably to the project.
Procedure for carrying out the study
1. Find out the nature and amounts of the environmental
resources to be used by the project, such as water, air,
and land.
2. Identify the nature and extent of the impact of the project
on various components of the environment.
3. Identify the areas surrounding the location of the project
that are effected by each type of pollution that the project
can cause, such as deposition of fly ash, spread of noxious
odours, etc.
4. Identify the components of the environment that are
destroyed by the project, such as extinct species of birds
and plants, scenic beauty and the possibility of preserving
them.
5. Evaluate the project’s desirability keeping all the above
factors in view.
There are many sophisticated methods of carrying out this
study that use checklists, matrices, networks and computers.
In any case, location of the project, technology and system
of effluent disposal are decided only after taking these
factors into consideration.