T = the terminal, or the last period of the project's life, and
r = the required rate of return.
You accept projects with positive NPV's and reject projects with negative NPV's. Projects with positive NPV's increase shareholder wealth. These projects earn more than the expected return that shareholders can earn on securities traded in the capital markets with the same amount of risk as the project, specifically the systematic risk as measured by beta. Projects with negative NPV's decrease shareholder wealth for the opposite reason.
However, in our development to this point, we concentrated on the after-tax cash flows in assessing projects. You were not given insights into how to determining the required rate of return on a project, or r. It is to this topic that we now turn.
II. The Required Rate of Return on Projects:
Our efforts in defining risk over the previous three chapters now allow us to return to the topic of capital budgeting. As discussed above, the term capital budgeting refers to the process of evaluating capital investment projects. We ask, should the firm acquire (or divest) particular capital assets?
As you may recall from Chapter 1 in RWJ and in Module #2, the objective of managers to . Remember, shareholders are the residual risk-bearers of the firm; shareholders supplied the capital that allowed the firm to spring into existence. Accordingly, managers work for the shareholders. Shareholders' best interests should underlie all managerial decisions.
Shareholders have abundant opportunities to invest in the financial markets in bills, bonds, stocks, convertible securities, etc. They do not want managers to retain money in the firm to invest in projects that do not earn returns at least as high as they can earn for themselves in the financial markets, adjusting for the risk of the projects. In this context, think of the Security Market Line (SML). Shareholders want managers to reject projects unless they at least match the risk-adjusted returns on the SML. Another way of making this point is to say, managers should not invest in projects unless shareholders earn their opportunity cost, i.e., the return they could earn in the financial markets on risk-equivalent financial securities.
Risk equivalency is a key part of the above statement. This concept is a major reason why we have spent so much time developing the notion of the appropriate measure of risk for an individual asset, or beta. As it turns out, beta is also the appropriate measure of risk for a project in a firm with public shareholders. We turn this measure of risk into a required rate of return for a project by using the CAPM pricing equation (SML), or
E(rj) = rf + (E(rm) - rf)βj, where
E(rj) represents the required rate of return on project j, and