Capital Asset Pricing Model (CAPM) PDF

Capital Asset Pricing Model (CAPM) Workshop 9 Learning Outcome In this session you will: ◦ be introduced to the CAPM and the asset beta formula and its components, understand how it can be used to estimate the cost of equity. ◦ applying the CAPM in calculating a project-specific discount...

Capital Asset Pricing Model (CAPM) Workshop 9 Learning Outcome In this session you will: ◦ be introduced to the CAPM and the asset beta formula and its components, understand how it can be used to estimate the cost of equity. ◦ applying the CAPM in calculating a project-specific discount rate. ◦ the theory, and the advantages and disadvantages of the CAPM. CAPM The CAPM is a method of calculating the return required on an investment, based on an assessment of its risk. Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the investment will be different from the expected return.  What is CAPM? The Beta is Alternative to A theory of Based on significant valuation asset price portfolio (co-movement theory for determination Theory and with the individual for firms Market Model market) firms.  Systematic and Unsystematic Risk-Recap ◦By diversifying investments in a portfolio, an investor can reduce the overall level of risk faced, therefore, an investor can reduce the overall level of risk faced. ◦There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not eliminate risk entirely. Systematic and Unsystematic Risk- Recap ◦ The risk which cannot be eliminated by portfolio diversification is called ‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the financial system. ◦ The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic risk’, or ‘specific risk’, since it is the risk that is associated with individual companies and the shares they have issued. ◦ The sum of systematic risk and unsystematic risk is called total risk (Watson D and Head A, Corporate Finance: Principles and Practice, 7th edition, Pearson Education Limited, Harlow pp.245-6). CAPM- Formula ◦ The formula for the CAPM is as follows: E(ri ) = Rf + βi(E(rm) – Rf) ◦ E(ri) = return required on financial asset ◦ Rf = risk-free rate of return ◦ βi = beta value for financial asset beta ◦ E(rm) = average return on the capital market Risk Free Asset & Risk Equilibrium ◦ -(Rf)In the real world, there is no such thing as a risk-free asset. Short-term government debt is a relatively safe investment, however, and in practice, it can be used as an acceptable substitute for the risk-free asset. ◦ Risk free rate - UK Note: The risk-free rate of return (the yield on short-term government debt) will change depending on which country’s capital market is being considered. The risk-free rate of return is also not fixed, but will change with changing economic circumstances ◦ - The equity risk premium ◦ Rather than finding the average return on the capital market, E(rm), research has concentrated on finding an appropriate value for (E(rm) – Rf), which is the difference between the average return on the capital market and the risk-free rate of return. ◦ This difference is called the equity risk premium, since it represents the additional return required for investing in equity. ◦ To smooth out short-term changes in the equity risk premium, a time-smoothed moving average analysis can be carried out over longer periods of time, often several decades. The equity risk premium UK & by country ◦https://www.statista.com/statistics/664833/average-market-r isk-premium-united-kingdom/ ◦ By Country The historical equity risk premium ◦ The historical equity risk premium approach is a well-­established approach based on the assumption that the realized equity risk premium observed over a long period of time is a good indicator of the expected equity risk premium. This approach requires compiling historical data to find the average rate of return of a country’s market portfolio and the average rate of return for the risk-­free rate in that country. ERP = RM - RF. Rm- average market return Rf- Average company risk free rate Beta Beta is a measure used to determine the volatility of an asset or portfolio in relation to the overall market. The overall market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. When applying the CAPM to shares that are traded on the UK capital market, beta values for UK companies can readily be found on the Internet, on Datastream, and from the London Business School Risk Management Service. Beta- Example If a share has a beta value of 1, if the return on the capital market as a whole increases by 10%, the return on the share will increase by 10%. Activity Task 2 Calculating expected returns Beta X market index risk premium x risk free rate of interest E (r )= Rf + (B x Rm) Example If share (A) has a beta of 2, and the riskless rate of interest is 7% and the premium for the market index has been 5%. Calculate the expected returns. = (2 x 5) + 7 =17% EXPECTED RETURN RF=2.5% BETA=1.25 MRP=8% CAPM-Using CAPM to estimate cost of equity Ram Co- The following information is given for Ram Co. ◦ Risk-free rate of return = 4% ◦ Equity risk premium = 5% ◦ Beta value of Ram Co = 1.2 Required Use CAPM to predict the cost of equity of Ram Co. Ram Co- Solution Using the CAPM: E(ri) = Rf + βi (E(rm) – Rf) = 4 + (1.2 x 5) = 10% The CAPM predicts that the cost of equity of Ram Co is 10%. The same answer would have been found if the information had given the return on the market as 9%, rather than giving the equity risk premium as 5%. Activity ◦Task 3 Beta- further aspects ◦ If a company has no debt, it has no financial risk and its beta value reflects business risk alone. The beta value of a company’s business operations as a whole is called the ‘asset beta’. ◦ When a company takes on debt, its gearing increases and financial risk is added to its business risk. The ordinary shareholders of the company face an increasing level of risk as gearing increases and the return they require from the company increases to compensate for the increasing risk. ◦ This means that the beta of the company’s shares, called the equity beta, increases as gearing increases Beta formula Illustration Calculating the asset beta of a company You have the following information: Equity beta of Tug Co = 1.2 Debt beta of Tug Co = 0.1 Market value of shares of Tug Co = $6m Market value of debt of Tug Co = $1.5m Tax 25% Answers After tax market value of company = 6 + (1.5 x 0.75) = $7.125m Company profit tax rate = 25% per year β a = [(1.2 x 6)/7.125] + [(0.1 x 1.5 x 0.75)/7.125] = 1.024.  ANY QUESTIONS