The capital asset pricing model in project selection: a case study.

Abstract

In this case study four actual energy efficiency project are analyzed with two traditional engineering capital budgeting methods - internal rate of return and payback period - and the results compared with those obtained using the capital asset pricing model (CAPM). The alternative scenarios of the future states-of-the-world necessary for the latter are based on information available in Department of Energy reports. The traditional and CAPM approaches result in different economic conclusions for some of the projects. These difference are analyzed and the implications for certain types of improvement projects and equipment replacement problems as well as financial decision-making in general are discussed.

INTRODUCTION

Among weaknesses in standard discounted cash flow techniques cited by Myers (1984) is included the uncertainty of cash flows. One approach that makes some allowance for this uncertainty is the Capital Asset Pricing Model (CAPM) of Sharpe (1964) and Lintner (1965). The model separates investment risk into diversifiable and undiversifiable risk, where the former is not rewarded because it can be neutralized by a careful selection of the total investment portfolio; only the undiversifiable or systematic risk of a project, then, merits a return premium.

The distinction between diversifiable and inherent systematic risk is particularly relevant in the case of energy efficiency projects because they too are subject to much of the inherent systematic risk of a well-diversified portfolio (stocks, bonds, land, plant, equipment, etc.). Examples of such risk include fluctuating exchange rates, commodity prices, interest rates, business cycles, trade agreements, deregulation, tax reform and the like. But the effects of these factors on most business investments and energy efficiency investments may or may not be similar. For instance, the elimination of the investment tax credit reduced the attractiveness of both. In contrast, the drop in oil prices increased the attractiveness of business investment in general but not energy efficiency projects and the effects would have been reversed for a price. While these examples seem obvious, estimating this varying impact of systematic risk is complex; yet it cannot be overlooked justifiably when selecting projects and budgeting capital.