The requirement here was for candidates to discuss how the capital asset pricing model (CAPM) could be used to calculate a project-specific cost of capital. The requirement gave a strong hint as to how this might be done by requiring the discussion to refer to systematic risk, business risk and financial risk.

Answers to this question were of variable quality. The key concept here is risk and better answers addressed the following points.

• Related project risk to the business risk of the proxy company. 
• Discussed the need to ungear the equity beta of the proxy company to an asset beta, in order to remove the effect of its financial risk element. 
• Discussed the need to regear the asset beta to an equity beta, in order to reflect the financial risk of the investing company. 
• Noted the need to use the CAPM to calculate a project-specific cost of equity. 
• Discussed how the final step would be in calculating a project-specific WACC.

Weaker answers limited themselves to saying something about each of the three kinds of risk mentioned in the question requirement, and saying little about how to calculate a project-specific cost of capital.

Definitions of business risk and financial risk were often quite vague. In the context of the question, both business risk and financial risk relate the variability of returns to the shareholder, since the CAPM calculates the cost of equity. Business risk relates to the variability of shareholder returns due to operational factors, which are factors that influence profit before interest and tax (PBIT). Financial risk relates to the variability of shareholder returns due to how a company finances its operations, which affects the relationship between profit before tax and PBIT. Business risk can be measured by operational gearing, while financial risk can be measured by balance sheet gearing or by interest cover. When risk is seen from this perspective, the CAPM makes much more sense as a way of calculating the cost of equity.