How to Use CAPM in Project Appraisal for Better Investment Decisions

Before we dive into the Capital Asset Pricing Model (CAPM), let's take a moment to consider how we might otherwise value our projects. So far, when evaluating the financing cost of an investment, we have been using the Weighted Average Cost of Capital (WACC).

However, WACC can only be used appropriately when certain assumptions are met, including:

1. The project is financed using pooled company funds
2. The project has a similar risk profile to the existing business
3. The company’s gearing (debt-to-equity ratio) remains unchanged

If the project’s risk profile differs significantly from the overall company's risk, then using WACC may lead to misleading results. In such cases, we need an alternative method to calculate the appropriate discount rate—and that’s where CAPM becomes useful.

To use CAPM reliably, a few key assumptions must hold:

1. Investors are rational, demanding higher returns for higher risk
2. Investors are well-diversified, meaning they are not exposed to unsystematic risk
3. CAPM considers only systematic risk, making diversification essential
4. The project is treated as an independent investment opportunity, not just part of the company’s operations

From the shareholders’ perspective, the project is one of many potential investments. It should be assessed on its own merits, with risk and return carefully evaluated.

❓Example 1: ABC Ltd

ABC Ltd is a company that is fully financed through equity and currently has an estimated cost of capital of 17% per annum. The management is considering undertaking a new investment project that is not identical in risk to the company’s existing operations. Preliminary analysis suggests that the project carries a higher risk profile, with an estimated beta of 1.3.

The risk-free rate in the market is currently 10%, and the expected return on the market portfolio is 20%. The company wishes to assess whether this project is financially viable by determining an appropriate discount rate using the Capital Asset Pricing Model (CAPM).

Using the information provided, calculate the required rate of return for the project using CAPM. Based on this, evaluate whether the company should use its existing cost of capital (17%) or adopt the CAPM-based rate as the discount rate for appraising the new project.

✅ Answer:

(1) The required return of the project

Cost of Equity (Ke) = Rf​ + β (Rm​−Rf​)

Where:

Rf = 10% (risk free rate)
β = 1.3 (Project beta)
Rm = 15% (expected market return)

Plug in the values

Ke = 10%+1.3×(20%−10%)
Ke = 10%+1.3×5%
Ke = 23%

Therefore, the required rate of return for the project is 23% per annum.

Since this is higher than the company’s existing cost of capital (17%), the company should use this 23% discount rate for appraising the new project, reflecting its higher risk.

What relationship does this have with the company’s overall cost of capital? In this case, we have calculated the project’s cost of capital by assessing its relative risk compared to the market. There is no direct relationship between the project’s cost of equity (Ke) and the company’s overall cost of equity. Remember, CAPM focuses on the relative risk to the market, not the internal risk profile of the company as a whole.

❓Example 2: Spirax Limited

Spirax Limited, an all-equity company with a beta of 0.6, is evaluating a new single-year investment opportunity. The project requires an initial outlay of $3,000 and is forecasted to generate $3,500 in cash inflows after one year.

Market data shows that government treasury bonds currently yield 10%, while the average return on the stock market index over the past several years has been approximately 18%. Independent analysts estimate the project’s systematic risk to be higher than that of the company’s overall business, assigning it a beta value of 1.3 based on comparable projects in the industry.

Using the Capital Asset Pricing Model (CAPM), calculate the appropriate discount rate for this project.

✅ Answer:

Risk-free rate (Rf): Given by the current yield on government treasury bonds = 10%

Market return (Rm): Average market index return = 18%

Project beta (β): Provided by analysts = 1.3

Discount rate for this project (Re):

Re = Rf​+β(Rm​−Rf​) = 10%+1.3×(18%−10%) = 10%+1.3×8% = 10%+10.4% = 20.4%

Cost of equity of Spirax Ltd

Re = Rf​+β(Rm​−Rf​) =10%+0.6×(18%−10%)=10%+0.6×8%=10%+4.8%=14.8%

Project's expected returns

Expected returns = (3,500 - 3,000) / 3,000 = 16.67%

🧠Decision:

1. The company’s overall cost of equity is 14.8%.
2. The project’s required return, reflecting its higher risk, is 20.4%.
3. The project’s expected return is 16.67%, which is higher than the company’s cost of equity but lower than the project-specific required return.

Since the project’s expected return does not exceed the risk-adjusted required return of 20.4%, the project should be rejected despite the expected return being above the company’s average cost of equity. This highlights the importance of evaluating projects on their own risk profiles, not just the firm’s average cost of capital.

Introducing Debt Finance

If we use CAPM as our project appraisal methodology, one of its greatest strengths is its ability to handle projects with different levels of risk and different levels of gearing compared to the company’s current capital structure. This flexibility comes from CAPM’s focus on systematic risk, which is captured by the beta coefficient.

Now, if we introduce debt finance into the equation, it will have two key impacts on the project’s risk and return profile. In fact, once we start considering the effects of debt, we step into the territory of the Modigliani and Miller propositions—specifically, the Miller-Modigliani model with taxes.

We'll explore this concept further in our next article on the capital structure of a company.

Instead of using just a single beta (β) value, we now consider multiple types of beta to reflect different aspects of risk. When evaluating both business risk and financial risk, the equity beta is used—it incorporates the total systematic risk faced by shareholders.

It’s important to remember that the majority of systematic risk is borne by the equity holders. However, if we want to isolate the business risk alone, independent of the company’s financing structure, we use what is known as the asset beta (also referred to as the unlevered beta).

The asset beta captures only the systematic business risk of the underlying project or company, excluding the effects of gearing (debt).

Why do we make this distinction?

Because in many cases, the project we are evaluating belongs to a different industry sector than the company itself. This means we cannot simply use the company’s existing beta (β) to appraise the project.

Betas are industry-specific, reflecting the unique business risk associated with each sector. Therefore, we must begin by using a sector average beta or the beta of a comparable (proxy) company within the same industry as the project. This allows us to more accurately assess the project’s risk relative to the market.

If we are evaluating a project in the oil industry, we might begin by looking at the beta of a well-known oil company such as BP, Mobil, or Shell. The beta we obtain from these companies will be their equity beta, which reflects both their business risk and financial risk (i.e., the risk arising from their capital structure).

However, financial risk varies between companies, depending on their level of debt. Since we are interested in the business risk specific to the industry, we need to strip out the financial risk component from the equity beta. This gives us the asset beta, also known as the unlevered beta, which captures only the systematic business risk.

If we can establish the asset beta for the industry, we can reasonably assume it applies to all companies operating within that industry, including the project we are assessing. Once we have this asset beta, we can then re-gear it using our own company's capital structure to calculate a new equity beta—one that reflects our company’s financial risk.

The interesting part is that the asset beta remains constant across firms within the same industry, and by re-gearing it, we tailor the risk measure to our own firm’s financing, allowing us to apply CAPM more accurately to the project.

🔁 Steps in Project Beta Adjustment and Evaluation

1. Identify Equity Beta (β) → Use a proxy company from the same industry
2. De-gear → Convert equity beta to asset beta (removing financial risk)
3. Re-gear → Adjust the asset beta using your company’s capital structure
4. Apply CAPM → Calculate the required rate of return using the new equity beta
5. Evaluate → Use the result to answer the question (e.g., accept/reject project)

βasset​ =  {Ve/(Ve+Vd(1-t))xβe} + {Vd(1-t)/(Ve+Vd(1-t))xβd}

In the formula, we include βd (debt beta). However, this value is typically quite small because the systematic risk associated with debt is much lower than that of equity. Debt beta values are often around 0.1 to 0.2, or even lower.

Additionally, the proportion of debt in the capital structure is usually relatively small compared to equity. On top of that, since interest on debt is tax-deductible, the effective weighting of debt in the calculation becomes even smaller.

Given these factors, if the debt beta is negligible, we can simplify the asset beta formula by ignoring the debt component. The simplified formula becomes:

$${\beta }_{\text{asset}}=\frac{V_e}{V_e+V_d(1-t)}\times {\beta }_{\mathrm{e}}$$

This version is commonly used in practice when the risk contribution from debt is minimal.

❓Example 3: Solstra Industries Ltd

Solstra Industries Ltd is a company engaged in the manufacturing of premium game collectibles. It operates with a stable equity-to-debt ratio of 5:3 and intends to maintain this capital structure for all future investments. The company’s corporate bonds, which are considered effectively risk-free, currently yield 10 percent per annum. The equity beta of Solstra Industries is estimated at 1.2, while the corporate tax rate is 30 percent. The current expected return on the market portfolio is 16 percent. 

The firm is evaluating a proposal to expand into a new line of business: custom 3D gaming figurines. A relevant proxy company in this niche, TitanWorks Pty Ltd, specializes in character collectibles and operates with an equity-to-debt ratio of 3:1. The observed equity beta of TitanWorks is 1.86.

Assume that the debt beta is zero for both companies, and that Solstra Industries will retain its existing capital structure upon undertaking the new project.

Required:

Using the CAPM approach, calculate an appropriate project-specific discount rate (cost of capital) that Solstra Industries should apply to the investment. Show all steps clearly, including:

1. Calculation of TitanWorks’ asset beta
2. Re-gearing of the asset beta using Solstra’s capital structure
3. Determination of the required rate of return (cost of equity) for the project using CAPM

✅ Answer:

Given:

1. Gross redemption yield (risk-free rate, Rf) = 10%
2. Average return on the stock market (Rm) = 16%
3. Corporate tax rate = 30%

Requirement 1: Calculate TitanWorks’ Asset Beta (Unlevered Beta)

We are given that the equity beta (βe) of TitanWorks is 1.86, and its equity-to-debt ratio is 3:1.

Ve = 3
Vd = 1x(1-0.3) = 0.7 (adjusted for tax shield)
Total Capital = Sum of Ve and Vd = 3 + 0.7 = 3.7
βasset​  = 3/3.7 x 1.86 = 1.51

Requirement 2: Re-gear the Asset Beta Using Solstra Industries’ Capital Structure

Solstra has an equity-to-debt ratio of 5:3. So:

Ve=5

Vd = 3x(1-0.3) = 2.1 (adjusted for tax shield)

Total Capital = Sum of Ve and Vd = 5 + 2.1 = 7.1

βasset​ = βe​ x {Ve / Ve + Vd(1-t)}

Rearrange the formula

βe = βasset x {Ve / Ve + Vd(1-t)}/Ve = 1.51 x 7.1/5 = 2.14

Solstra Industries is more highly geared than TitanWorks, which results in a higher equity beta (2.14) when the same business risk is adjusted for Solstra’s financial risk. This reflects the additional risk borne by equity holders due to higher leverage.

Requirement 3: Determination of the required rate of return using CAPM.

Given:

1. Risk-free rate (Rf) = 10%
2. Market return (Rm) = 16%
3. Equity beta (Be) for the project (re-geared) = 2.14

Apply the CAPM formula:

Required rate of return (Re) = Rf + Be × (Rm – Rf)
= 10% + 2.14 × (16% – 10%)
= 10% + 2.14 × 6%
= 10% + 12.84%
= 22.84%

Weighted Average Cost of Capital (WACC)

	Value (V)	Cost (K)	Total (VxK)
Equity	5	22.84%	1.142
Debt (10% x (1-0.3)	3	7.00%	0.21
Total	8		1.352

WACC = 1.352 / 8 = 16.9%

🔍 Final Project-Specific Discount Rate (WACC): 16.9%

Solstra Industries should use a 16.9% discount rate when evaluating the proposed expansion into custom 3D gaming figurines. This rate reflects both the business risk inherent in the new line (as captured through the asset beta of TitanWorks) and Solstra's own financial structure (its higher leverage compared to TitanWorks).

This discount rate will ensure that the project is evaluated appropriately, factoring in:

1. The risk-free return (10%)
2. The systematic risk of the new business (via beta)
3. The higher financial risk borne by Solstra’s equity holders
4. The benefits of debt financing, such as the tax shield

This WACC (16.9%) should now be used as the hurdle rate for evaluating future cash flows from the custom figurine project. If the internal rate of return (IRR) from the project exceeds 16.9%, the project adds value and should be considered viable.

Updated: 13th July 2025 4:11 PM