Hi,
I am preparing for an M&A interview & case in which I will likely have to use CAPM, WACC and beta's to value companies. However, I have always felt like CAPM and beta were not the way to calculate discount rates. For me the discount rate would be the alternative with the highest expected return that I want to do.
Consider the following situation. The market (economy proxy) has 5% expected return. Let's say I have project A with a 5% guaranteed return. If alternative project B has a 10% expected return (beta = 2) but I consider it too risky (for example 90% of 0 return, 10% of 100% return), I can consider my 8% alternative project C (50% chance of 12% return, 50% chance of 4%) as the project with the highest expected return that I want to do. So even though I get 5% guaranteed return on my project A, I will have to discount it with 10% (project B if my finances allow the risk of downfall) or 8% (project C if project B's cash flows are too risky).
The reason I doubt CAPM is because it assumes volatility is more risky, but in reality it means higher payoffs can be realized as well? Only a risk averse investor would require a premium for volatility, but the model assumes a risk-neutral investor. Project B can have the same expected return as project A (let's assume for a second that project A is guaranteed 10% return) but my love for risk means I could accept a discount (rather than premium) on choosing project B, meaning I could take the riskier project B for something like 9% return over the guaranteed 10% return.
You don't have to control for risk using a variable as you are already doing so by comparing the project you are evaluating with your best desired outside option. If you would decide to invest in "risk free" bonds with 1% return whereas you could invest in a 8% expected return project (which you can afford to do as your financials allow you to survive a downswing/low realized return), your discount rate from investing in the bonds would be 8% and not something close to 1% from investing in some other risk free asset. I hope you understand what I am trying to say. Lastly, historical price moments are no guarantee for the future and the same thing holds for volatility. Therefore, historical beta has no value and future beta for a project cannot be calculated.
I have often read that CAPM is an imperfect ROE/COE measure and with this topic I hope to discuss the topic and provide my alternative. As it stands, I will have a hard time making professional valuations if I disagree with the model.
Kind regards,
edit: Google "Warren Buffet on discount rate" and you will find that he uses 30y risk free Treasury Bonds as his discount rate as he believes time value of money does not depend on what type of business you invest in (high risk or low risk for example). He sees the valuation using this low discount rate as the upper max valuation and then creates a margin of safety using higher discount rates as to ensure the business he's investing in is priced too low.
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