βj represents the risk of project j.
This return becomes our discount rate in our NPV calculations.
II. The One-Asset Firm:
Let's begin our discussion by considering a one-asset firm. Since we want to defer the impact of the financial structure decision on the wealth of shareholders till later, we will initially that firms are .
Let's begin with a simplified, market value balance sheet with "real" assets (as opposed to financial assets) on the left-hand side and financial assets, here all equity, on the right-hand side.
A1 = Asset S = Stock
(Asset Risk =(Financial Security Risk =
Business Risk) Financial Risk)
Total Assets = Total Equity
Asset Beta, βA = Equity Beta, βS
Given the CAPM, the required return for the real asset A1 equals
E(rA1) = rf + (E(rm) - rf)βA1, where
βA1 is the beta of Asset A1.
However, there are some complications in determining the asset's beta, βA1. Therefore, we must digress for a moment.
What does a financial security (in this example, common stock) represent? A financial security is just a piece of paper! Intrinsically, this piece of paper has no value. Why, then, do financial securities, such as shares of common stock, have value in the marketplace? It is because financial securities represent claims on the cash flows generated by real assets, or the assets that "live" on the left-hand side of the balance sheet! In other words, the source of value of financial securities is derived from the cash flows generated by the real assets and the risk of these cash flows. Different types of securities, e.g., stocks and bonds, have different priority claims upon these cash flows. Again, however, in our example we are only considering an all-equity financed firm.