We read a little about project beta in CFA level I curriculum. Most of the guys just remember the formula to calculate project beta and forget it after the exam. It is one of the most important things in corporate finance and the candidates, who are dreaming of getting a corporate finance job, must not forget about the importance of project beta.
The project beta is calculates using the pure-play method. In the pure-play method, we calculate the beta for a publicly traded company who is purely in that particular business only. Let us take an example. Suppose Apple wants to enter into automobile sector and you are an analyst responsible for making the decision whether to undertake that project or not. You would calculate the betas for the companies which deal in automobiles only. Then you need to unlever all the beta as every company might have different debt proportion in their capital structures. (Remember that higher is the proportion of debt in the capital structure, the higher is the beta of the company. Higher is the financial leverage, greater is the variability of the earnings and this higher betas.) On unlevering the beta for each company, you will get the asset beta which will show the systematic risk for the business only without any leverage. Now you need to average the unlevered betas and use that average beta as the asset beta for the project.
Asset beta = Equity beta/[1+(1-t)D/E]
After getting the asset beta from the pure-play method, you need to again relever it for Apple. After levering the beta, you have the project beta which should be used in calculating the cost of equity for the project.
Equity beta = Asset beta*[1+(1-t)D/E]
After calculating the cost of equity, you will calculate the cost of capital and compare with the IRR of the project or use that cost of capital to compute the NPV of the project to make the final decision. Now here comes the most important part where most of the corporate finance managers make silly mistakes. While comparing the IRR of the project, the compare it with the cost of capital of the entire company rather than the cost of capital for that particular project.
Suppose you are a CFO of a company who gives the final decision about the projects. You know that the cost of capital for your entire company is 10%. Suppose you are a CFO of a bank. The bank has mainly two business: commercial banking and investment banking. The commercial banking has a lower beta and also provide lower but safer returns. The investment banking provides higher but risky returns having greater betas. Now suppose you compare the IRR of the different projects with the cost of capital of the firm, you are going to punish the safer businesses and encourage the risky businesses. What will happen eventually? You will choose all the investment banking projects and start ignoring the commercial banking projects. Suppose the cost of capital for commercial banking projects is on an average 8% and for investment banking projects, it is 12%. If an investment banking project with an IRR of 11% comes to you and you compare it with the cost of capital of the firm (which is 10%), you are going to accept the project while it shouldn’t have been accepted with the correct usage of project’s cost of capital. Similarly, a project in commercial banking providing an IRR of 9% will be rejected although it should have been accepted. When you keep on doing this for a number of projects what will happen to the total cost of capital? Obviously, it will shoot up to 12% and you will come into danger and your bank might go bankrupt if it couldn’t provide more return than the hurdle rate.
You will be thinking that this is pure common sense and who will make such silly mistake. But if you look at the companies who are in multiple businesses, more than 50% of the companies make this mistake and eventually pay the price either with low or negative earnings or bankruptcy. You must set the hurdle rate of the business looking at the riskiness of the business. If you are in investment banking business, it’s hurdle rate should be at least 12% rather than using the cost of capital of the firm which would be lower than 12%.
There are various reasons why many corporate finance managers, even after knowing it, tend to ignore it and go with the cost of capital of the firm. That makes it an interesting topic of Ethics as well. The managers have pressure to provide the ever-increasing earnings. Their bonuses depend on that. They look for the short-term and forget about the long-term. In the short-term, the firm will be able to take multiple projects and the earnings and share price will rise, leading to a good bonus for the managers. But in the long-run, the stockholders of the company would get punished because of it. Managers will still take their salary with them. Even if the company goes bankrupt, they can always shift their job to other company. These personal and many other political reasons lead to such errors in corporate finance and then people start blaming the academicians for the models like CAPM for calculating the cost of equity.
I hope that now all of us have understood the importance of project beta. If we remember the importance of project beta, there is little chance that we would get a question related to project beta wrong in the CFAI level I exam. That is the additional benefit of knowing its importance. 🙂