All right. Welcome to the area of practical uses of CAPM. Let's start with the following situation. This is the chart so this is beta. This is expected returns, and we know that this is RF, this is RM, this is zero, this is one. So we produce the security market line, which is as we all know, a graphical representation of CAPM. Now, so this line basically says that any project that is above this line is good, because it has a positive NPV. Why? Well, supposedly the project is somewhere here. Then, we know that the market expected return for that lies on this line, so it's here. So if we discount the project with this return at a lower rate, it is very much likely to have a positive NPV by the same token if it lies below this line, then it's a poor project. You have to say, well, in some previous episodes we talked about the fact that, on average, all securities have to be on this line. Indeed, that's right but we talk about the projects that maybe are not on the market, that are before even issuing stock, and actually, those may be new projects that previously have not been included in our discussions, so there's no contradiction here at all. I'll tell you more, that the whole idea of the use of CAPM, it's based on the idea that there are quite a few projects that we have to analyze, and these projects, they are not on the stock market. Because we will see in the next episodes, if there is a stock traded, then most of each returns, most of its risks, bait and everything, it can be somewhat taken from the market data. And also, you can say, well, this company's stock is traded, so for any moment in time, they resist the correct market price of this company or this project if it's traded. Now, what's the use of coming up of all these things? Well, the answer is very simple. For the vast majority of projects, of these projects, of these companies are private, and they're not traded. So we have to somehow use the market data to come up with proxies for the evaluation. And this is the key goal of any evaluation procedure for most of the projects, and that is what the people in corporate finance area do. That is what we're starting to do right now. Let's take sort of a corporate view. You have a company, and in your new company, there's plenty of projects. And strictly speaking, this formula tells us that for each and every project, we have to identify its risk and therefore, what we like to evaluate this project with the use of corresponding rate of return that is correct for this risk. So strictly speaking, if a company has lots of projects, so this has to be taken as a portfolio of these projects, and within this portfolio, each and every project has a various special rate of return or the rate of discounting. Well, in many cases, this is a cumbersome procedure in terms of corporate management. Therefore, people may say, what if we used a uniform? That's called, the company cost of capital rule so this will be the average beta of the company's assets. And we will use the same rate or the same level of risk for all projects in the company. Well, what problems does that create, and what potential damages can be inflicted here? Let's take a look, first of all, on this chart. So basically, the company cost of capital rule tells us that we accept all projects with the rate of return above triple C, and we reject all projects that go below triple C. To some extent, that can be called the case when the company uses the sort of internal rate of return method of choices or making decisions, which we know is not a perfect one, but still this is a very realistic and think that people indeed are using. Let's try to compare. So the first criterion here is the sort of normal, correct, of the market criteria is that, you have to take the projects that lie above the SML, and reject the ones that lie below, and the company cost of capital rule is different. Well, you can see that these two lines, they intersect them, they actually are not the same criteria. So let's start with this area. So this area that is both above the triple C rule and above the SML rule. This is sort of an area like this. Clearly, you can say that this is the area of good projects, good by both criteria. So here, we are kind of safe. By the same token we can say that this area which is below both lines. This is the area of bad projects, and here, there is no challenge and no contradiction. However, what about this area, if we find the project here? Well, this project has a positive NPV, because it lies over the SML line, but it will be rejected by the company. So this is the area of rejected good projects. Well, that's too bad, but this is not the real damage. What about this project? You can see that it is likely to be taken by the company because its return exceeds triple C, but it has a negative NPV. So this is the area of accepted bad projects so this is really the damage area here. Now, you can say, well it seems to be kind of stupid to apply the triple C rule because clearly, we are taking significant risks here. But the problem is and again, I can give an example. Let's say, you are a holding company, and you have one company that's an oil company, and the other that is the utility company. And you cannot require the same rate of return for projects in the oil industry and the projects in the utilities industry. The second one will be much lower. And if this is the case, you can easily draw this distinction. However, in many cases, your projects are close in terms of risk, and then this problem is mitigated. And also, we are again, dealing with the process of corporate decision-making. Later in this course and in our six week, we will say a few words about some other criteria including EVA and MVA, and we will see that these are also very close to NPV, but they are easier to use in the corporate decision-making environment. So you can always say that it does depend upon the actual difference of the average beta of this company from the projects they have. So, if this is likely, and the average beta is here, both projects are there, then these projects should be treated differently. If all projects are somewhere here, then the risk that you're taking is much more moderate. Now, so that gives you the idea that oftentimes, it is really easier to use a more simplified criteria, but still keeping in mind the CAPM or SML, which is actually the same. And from here, I would like to proceed by saying, well, let's try to use CAPM to come up with these expected returns. So that was just an example of how we can, let's say "misuse" some of the criteria. Although, this is very important and is widely seen in reality, but from now on, we will go ahead and say, "Well, let's analyze how we can come up with this required rate of return for an actual project or an actual company." First, we will do that for a trivial case with no debt, and then we will proceed and try to study a more general case.
