Economics Capital Budgeting Questions
The capital asset pricing model (CAPM) is a financial model that helps determine the expected return on an investment based on its risk. It is used in capital budgeting to estimate the appropriate discount rate for evaluating potential investment projects.
CAPM suggests that the expected return on an investment is a function of the risk-free rate of return, the beta (systematic risk) of the investment, and the expected market return. The formula for CAPM is:
Expected Return = Risk-Free Rate + Beta * (Expected Market Return - Risk-Free Rate)
In capital budgeting, the CAPM is used to calculate the cost of equity, which is the expected return required by investors for investing in a particular project. The cost of equity is then used as the discount rate to calculate the net present value (NPV) of the project.
By using CAPM, companies can assess the riskiness of an investment project and determine whether it is worth pursuing. Projects with higher expected returns compared to their risk are more likely to be accepted, while those with lower expected returns may be rejected. CAPM provides a systematic and quantitative approach to evaluate investment opportunities and make informed decisions in capital budgeting.