· The project and the firm are all-equity financed.
However, what if the firm was considering another asset that would produce products of a distinctly different type from the existing products. For instance, what if Geneva Steel was considering going into the fast-food business? Clearly, the required rate of return for steel-type projects would be different than the return shareholders require for a fast-food chain.
In this case, we cannot use the beta for a steel stock to evaluate an investment in the fast- food business. What would we do?
Recall the SML.
The SML line is the pricing model of the CAPM. The measure of risk in the CAPM is beta.
Steel equity betas are determined by assets that generate steel and steel sales cash flows. Let this beta equal βA1 in the above diagram. The required return on assets with this level of risk is E(rA1) Assume that fast-food equity betas are determined by assets that generate fast-food cash flows. Let this fast-food beta equal βA2 in the above diagram. The required return on assets with this level of risk is E(rA2).
Therefore, if Geneva Steel were contemplating an investment in the fast-food business with risk βA2, Geneva should use E(rA2) as the discount rate, and the rate appropriate for steel-related investments, E(rA1).