Question

Explain why the CAPM was a step forward in Finance theory.

Answer 1

The impact of the cost of capital on optimal generation portfolios

In theory, according to the Capital Asset Pricing Model, the cost of capital should change with the portfolio as each portfolio corresponds to a different degree of risk exposure. For practical reasons, using a constant discount rate (e.g. the company cost of capital) is common for investment valuation, particularly when the impact of risk is already taken into account through Monte Carlo simulation. The results were presented using a 10% average post-tax weighted average cost of capital, which appears realistic for investment evaluation in liberalized electricity markets. However, power investment projects are often underpinned by specific contractual arrangements to transfer some of the construction, operational or market risks away from the plant investor toward other stakeholders. For instance, ‘turn key’ contracts for part or the whole plant, such as the one between AREVA and TVO for the nuclear plant under construction in Finland, significantly lower the risk exposure of the plant investor and should allow access to cheaper debt financing. Governments might also want to intervene to facilitate access to cheaper financing by underwriting some of the risks associated with a specific technology.20 This section presents a sensitivity analysis of the main results to a lower (5%) discount rate, which can be interpreted as a case in which plant investors have managed to shift away onto other stakeholders major project risks, thereby obtaining favorable financing conditions.