Factors affecting risks and returns of Project

Unsystematic Risk Systematic or market risk Financial Risk/Gearing Market risk and Gearing Combined

Portfolio theory CAPM theory MM theory CAPM and MM combined

Risk minimized by Beta measures or MM 1963 equations
Diversification Market risk To be used for diversification

Cost of Capital is measured Cost of Capital is measued Formula to determine cost of

after considering market after considering debt/eqity is same as in CAPM.
risk of project only,using: ratio of project only,using: But obtain Beta from following:

Rf+(Rm-Rf)ß Ke(geared)=Ke(ungeared)+ ß equity ungeared=ß equity geared×E/(E+D)

This step will give Cost of 1-t(Keu-Kd)D/E
Equity-ungeared It will give Ke(ungeared)
 Project Appraisal Discount Rate-Decision Tree

Does proposed project has same business risk as that of company

Yes
Is Financial risk of project different from that of company
Yes
Is project debt risk free

No Yes

Is project debt perpetual/irredeemable

Yes Yes

Are amount of debt or increase in borrowing capacity Is Debt-Equity ratio of project given
or issue costs on new loans/equity or subsidized in question
loan given in question
Yes Yes
No

Use APV approach Use Cost of Capital-adjusted approach

Ungear Company to obtain

pure cost of equity using
company's own gearing ratio

Recall that cost of equity of

ungeared company can be
derived from MM Formula:

Ke(geared)=Ke(ungeared)+
1-t(Keu-Kd)D/E

Find Base case NPV Obtain cost of equity-geared

using Cost of Equity-ungeared of project using debt equity ratio
as discount rate of project-regearing by following:
Ke(geared)=Ke(ungeared)+
1-t(Keu-Kd)D/E

P.V of Tax shield Calculate WACOC-adjusted

discounted at risk free rate

P.V of other side effects(issue P.V of cash flows discounted

costs,subsidized portion of loan, at WACOC-adjusted
increase in debt capacity)
discounted at risk free rate
 Project Appraisal-Discount Rate in case of Diversification

Does the project has business and financial risk different to that of company
Yes Yes

CAPM and MM Combined

APV method or MM 1963 equations

Obtain Beta value of the industry same

in which investment to be made

Convert idustry geared beta to same

ungeared beta using following:

ß equity ungeared=ß equity geared×E/(E+D)

This will give beta as if the project was fully

financed by equiy

N/A Convert ungeared beta to geared beta

using debt-equity ratio of project

Calculate required return on project/cost Calculate required return on project/cost

of pure equity by following formula of pure equity by following formula

Rf+(Rm-Rf)ßungeared Rf+(Rm-Rf)ßgeared

Find base case NPV of project Determine WACOC-adjusted

using required return on project
as discount rate

Determine P.V of tax shield Determine P.V of project using WACOC-

and other side effects adjusted