A Simple Method For Assessing Project Risk By Adjusting For Growth Options Leverage
Capital budgeting methods require estimates of project betas which, using the Capital Asset Pricing Model (CAPM), allow the authors to estimate the cost of capital used for discounting expected future cash flows. In practice, equity betas are estimated using stock returns of comparable firms which are then unlevered for financial leverage to estimate asset betas. They show that asset betas estimated in this way overestimate project risk because they include growth options leverage. They show a simple method for unlevering asset betas for growth options leverage which can then be used to properly value investment projects.