Capm - Environment Analysis

Capital Asset Pricing Model (CAPM) and Capital Budgeting Sometimes it is difficult to estimate the return expected by the company’s equity providers, which makes the estimation of the rate of discount suitable to the project impossible. A new company has no way of knowing the returns that equity providers expect and what its cost of capital is going to be. In such cases, CAPM is useful tool. The application of the CAPM in finding the rate of discount suitable for a project is as follows: 1. Obtain a sample of betas of firms engaged in the same line of business as the proposed project. Betas of firms engaged in the same line of activity and are comparable in size and scale should be obtained. 2. Obtain assets beta from the equity betas: Just as the equity has a beta, assets also can be assigned a beta value and it can be found given the equity beta, debt-equity ratio an the tax rate.

The securities - equity and debt issued by a company; the beta of the portfolio (βp) is equal to the beta of the assets (β A) of the company. βp = β A Eqn. 1 The beta of the portfolio can be expressed as the weighted average of the betas of the debt and equity issued by the company. That is, βp = β E [E / (E + D)] + β D [( D / (E + D)] Eqn. 2 Since βp = β A , β A = β E [E / (E + D)] + β D [( D / (E + D)] So, β E = β A + (β A - β D ) x D / E If the beta of the debt is assumed to be zero ( this means that debt is considered to be risk-free), we get βE = βA + βA x D = βA 1 + D Eqn. 3 E E or β A = β E / 1 + D or β E = β A 1 + D ( 1 –T) for tax shield Eqn. 4 E E of debt Eqn. 5

And, β A =

βE 1 + D ( 1 –T ) E

Eqn. 6

Once the assets betas of all the firms are calculated, the average β A should be calculated. 3. Calculate the average equity beta for the proposed project from the asset beta. The equity beta can be calculated using equation 5 4. Apply the CAPM to find out the return required on the equity: Re = Rf + ( Rm – Rf ) β E where Re = Return required on equity Rf = Risk-free rate Rm = Return on market folio β E = Equity beta

5. Find the weighted Average cost of capital for the project. WACC = WeKe + WdKd ( 1-T ) We = Weight of equity in the capital Wd = Weight of debt in the capital Ke = cost of equity Kd = Cost of debt T = Tax rate Exercise: Magnum Limited is considering a cement project for which it proposes to employ a debt-equity ratio of 2:1. Its pre-tax cost of debt is 16% and the tax rate is 30%. There are three firms A, B, and C engaged in cement manufacture. Their tax rate is 30%. Their equity betas and debt-equity ratios are as under: A 1.25 2.25 B 1.15 2.00 C 1.10 2.10 The risk free is 12% and the expected return on the market portfolio is 17%. Find out the required the rate of return.

Solution: 1. Calculation of assets betas From the given information and equation 6, asset betas are: A : 0.485 B : 0.479 C : 0.445 The average is 0.47 ≈ 0.50 2. Calculation of equity betas Using equation 5, The equity beta of Magnum : 0.50 { 1 + 2.0 ( 1- 0.30)}=1.20 3. Calculation of expected rate of return ( cost of equity) Ke = Rf + β ( Rm – Rf) = 0.12 + 1.20 ( 0.17 – 0.12) = 0.18 or 18% 4. Calculation of WACC –(required rate of return) WACC = WeKe + WdKd ( 1-T ) = 1/3 x18 + 2/3 x 16 ( 1 - 0.30) = 13.46%

Environmental Appraisal of Projects 1. Factors that can induce the corporates to behave in a more environmental friendly manner:  Pollution control regulation  Consumer pressure  Pressures from the local people and  Pressure from the investors 2 What is Environmental Pollution? The environment of man consists of everything that is outside him. It is earth, all things on it, surrounding it and within it. It consists of living and non-living components. The life component includes the plants, animals and micro-organisms. The non-life components consists of the land, water, air, clouds, sunshine, etc. In relation to a project, “environment can be defined as the surrounding area within which the life and non-life components are subject to the influence of

of the project” According the Environmental ( Protection ) Act, 1986, ‘ environment’ includes water, air, and land and the interrelationship which exists among and between water, air and human beings, other living creatures, plants, microorganisms and property. The definition includes the interactions between the non-life components and their interactions with the living creatures also. Sources of Pollution: Air and water are the major perpetrators of pollution. Liquid, solid or gaseous fuel can pollute air in the form of smoke. Road vehicles, air crafts, ships and rail engines – all contribute to pollution of air. Water pollution is more complex. There are many ways in which water gets polluted : a) Dumping of industrial affluents on the ground b) Pesticides used for agriculture c) Fertilizers d) Waste materials dumped on the ground reach rivers

e) Industrial wastes discharged directly into sewage canals. f) Discharge of sewage from communities into rivers and lakes. Pollutants released by various industries  Tanneries  Textile industry  Distilleries  Fertilizers  Steel mills  Oil refineries  Drugs and pharmaceuticals  Sugar  Chemicals – Dyes and dye intermediates Methods of Effluent Treatment Air Pollution Mechanical separation Elecrostatic Precipitation Filtering

Scrubbing Treatment water pollutants  Primary treatment  Secondary treatment  Tertiary treatment Environmental Laws in India The Water ( Prevention and Control of Pollution) Act, 1971 The Air ( Prevention and Control of Pollution) Act, 1981 The Environmental ( Protection ) Act, 1986 Environmental Impact Assessment of Projects A study of the environmental impact is called Environmental Impact Assessment (EIA) and a statement of the impact is referred to as Environmental Impact Statement(EIS). EIS is defined as the the identification, prediction, interpretation and communication of information about the impact of a project on man’s

health and well being. It is the study of the changes in the socio-economic and bio-physical attributes of the environment, which may result from the project. EIS contains the following: i. Description of the project, purpose, and technical details ii. Effect on the land use plan, policies and controls in the surrounding areas. iii. Impact of the project on each component of the environment. iv. Possible alternative projects that do not cause adverse effects as foreseen in the present project. v. Proposed measures to contain the adverse effects of the projects on the environment. vi. Amount of unavoidable pollution in spite of taking all possible measures to avoid the undesirable impact on the environment. vii. An evaluation of the commercial and social desirability of the project in comparison with the pollution caused.

viii. Amounts of resources that have to be committed irretrievably to the project. Procedure for carrying out the study 1. Find out the nature and amounts of the environmental resources to be used by the project, such as water, air, and land. 2. Identify the nature and extent of the impact of the project on various components of the environment. 3. Identify the areas surrounding the location of the project that are effected by each type of pollution that the project can cause, such as deposition of fly ash, spread of noxious odours, etc. 4. Identify the components of the environment that are destroyed by the project, such as extinct species of birds and plants, scenic beauty and the possibility of preserving them. 5. Evaluate the project’s desirability keeping all the above factors in view.

There are many sophisticated methods of carrying out this study that use checklists, matrices, networks and computers. In any case, location of the project, technology and system of effluent disposal are decided only after taking these factors into consideration.