The Relationship Between Risk and Expected Rate of Return in CAPM - Statistics Project Example

Introduction In finance, Capital Asset Pricing Models (CAPM) is used to describe the relationship between risk and expected rate of return while dealing with pricing of risky securities. In simple words, this method is helpful to compute the required rate of return of an asset when that asset is invested with a business venture. The capital asset pricing method offers some productive concepts. According to this concept, the investors have to be compensated on the strength of their time value of money and risk. Time value of money represents the period of time an investor placed his money in any investment. At the same time, the risk factor offers price to investors for investing their money in risky securities. The sum total of both these factors gives a clear view regarding the expected rate of return on a particular asset. It is generally calculated by using a risk measure called beta. This paper will discuss whether the capital asset pricing model should be used to estimate the Net Present Value of a project. Capital Asset Pricing Model The CAPM was originally developed by Harry Markowitz in 1952 and it was fine-tuned by others including William Sharpe. As stated above, CAPM calculates rate of return of an asset by adding the value of risk taken with duration of investment. The formula used to describe the CAPM relationship is illustrated below. Required (or expected) Return = RF Rate + (Market Return – RF Rate)*Beta. In order to clearly determine the applicability of CAPM, it is necessary to discuss the working method of the model. Assume that risk-free rate is 5%, the beta measure of the stock is 3, and the expected rate of market return for this period is 12%; then the expected rate of stock becomes; 5%+3(12% - 5%) = 26% In the opinion of Roll and Ross (1980, pp.1073-1103.), this theory had considerable significance in empirical work during 1960’s and 1970’s. However further researches on this concept have questioned its reliability and authenticity of the computation of empirical constellation of asset returns; and, many related theories have detected ranges of disenchantment with the CAPM. As a result, the most widespread CAPM underwent harsh criticisms not only by the academicians but also by financial experts. In addition, empirical researchers have gathered a range of evidences against this model during the last few decades. Those evidences questioned the model’s assumptions and argued the dead of the beta. Roll and Ross (1980, pp.1073-1103.) say that this situation led to the demand for a more potential theory and it caused the formulation of Arbitrage Pricing Theory (APT). Although, APT was developed recently, CAPM is considered as the basis of modern portfolio theory. According to Shanken (1982, pp.1129-1140), the ATP is not more susceptible to empirical verification than the CAPM. The author also challenges the testability of arbitrage pricing theory as he finds that the basic elements of testability strategy would not properly work in the case of this model. He also points out that the theory precludes the differentials of expected return that form the basic structure of the concept. Huberman and Wang (2005, pp. 1-18) claim that both the CAPM and APT show relation between expected returns of assets and their co-variance with other random variables; and an investor cannot avoid some types of risks by diversification and the concept of covariance is interpreted as a measure of such risks. There is only a single non-company factor and a single beta for CAMP and this formula only uses market’s expected return. Under CAPM, it imposes certain strict restrictions regarding individual portfolios and hence the requirements of this model also are much restrictive.However, the level of applicability of this theory is still a debatable topic in international economic conferences. In order to reacha conclusion regarding the efficacy of CAPM in the estimation of Net Present value, it is essential to discuss various aspects of NPV as well as the strengths and weaknesses of CAPM model in detail. Net Present Value (NPV) According to Slee (2011, p.584), NPV can be simply defined as the difference between the current value of cash inflows and current value of cash outflows. This method is widely used in capital budgeting to estimate the possible returns from an investment or project (ibid). In order to determine potentiality of a project, NPV compares the present value of a currency to the value of that same currency in the future by taking inflation rates and returns into account. As per economic theories, a project would be recommendable to an investor if its NPV is positive. In contrast, an investor must reject a project with a negative NPV because its cash flows would also be negative. To illustrate, if a chemical manufacturing company wants to purchase an existing store, it must fist estimate the possible future cash flowsthat this deal would generate in future and then discount the identified cash flows in one lump-sum present value, say £590,000. If the store’s owner is willing to sell his property at a price less than £590,000, the NPV of the investment becomes positive and therefore the chemical company may go on with this acquisition plan. In contrast, if the store’s owner demands more than £590,000 for his business, the investment would represent a negative NPV and hence the chemical company must terminate the purchase plan. Strengths of the CAPM The CAPM was developed over a half century ago and still it has a significant influence on the estimation of investment returns despite the argument that this method does not address realistic market conditions. Pratt and Grabowski (2010, p.32)point out that the CAPM completely eliminates unsystematic risk, or risk elements specific to an organisation or industry. Therefore, this model is simple and it has a higher degree of “reasonableness”. The CAPM has been empirically tested by researchers many times using proxies (approximate estimates that investors employ to compare against their investment) for the different variables. One of the main advantages of the CAPM is that this method specifically focuses on industry standard in the context of calculating proper return benchmarks for regulated industries. In the opinion of Mabrouk and Bouri (2010), comparing with other similar methods, CAPM is very easy to implement and interpret and hence even anordinary businessman can easily assess a project using this model. In addition, another strength of this theoretical frameworks is that “the implied ‘beta’ estimates for regulated industries can normally be expected to lie below, but not very far, from one, hence the approach is in practice fairly close to using the market return as the appropriate equity benchmark” (Civil Aviation Authority, 2001, pp. 1-33). Furthermore, CAPM is the best available method to take better investment decisions as compared to other alternative models. Weighted Average Cost Capital (WACC) is another alternative to CAPM and it works based on the assumption that the investment project does not bring any variation either in the business risk or financial risk of the investing organisation. The usage of this investment analysis tool as discount rate during the course of investment appraisal may sometimes lead to an incorrect investment decision because its internal rate of return would be less than that of the WACC. In the case of CAPM, the project’ internal rate of return is above the security market line and this return will be greater than that needed to effectively offset the systematic risk. Discount rate The tool of discount rate is used to evaluate “how much money should be invested at a given interest rate in order to achieve a particular amount at a defined period in the future” (McCrie, p.255). Capital asset pricing is one of the common methods employed to calculate proper discount rate in the assessment of net present value or business valuations. Business houses mainly practice the discount rate tool when deciding whether to spend their surpluses to acquire an asset or to distribute it among shareholders. In practice, businesses spend the profit on the purchase of additional assets only if the shareholder would get a more attractive amount later. The capital asset pricing method is very helpful to estimate shareholder’s discount rates by means of share price data. Traditionally, business firms apply the tool of discount rate to estimate the net present value of an asset and thereby to evaluate the potentiality of the purchase decision. CAPM in the estimation of NPV The regression analysis of a project discloses that the size of a company in the cost of equity capital influences the efficiency of the firm. Even though the CAPM has been adopted by economists to enhance investment decisions in the stock market, it has been widely used for investment analysis in project management as it identifies the relationship between risk and return. There have been many intellectual challenges associated with the application of Capital Asset Pricing Model in estimating the Net Present Value of a project. The empirical evidences reveal that smaller firms obtained a higher return than forecasted by the CAPM.Suppose a firm is making plans to invest in a project, it will cost money today but will result in higher revenue in the future. In other words, there will be cash outflow today and cash inflows tomorrow. The financial riskconnected with a project is generallyrecognised with a risk adjusted discount rate making use of the Capital Asset Pricing Model, a keystone of modern financial theory. According to Mabrouk and Bouri (2010), the principle of the model is that the estimated investment return varies in proportion to its associated risk of the project, i.e., if the investment faces more risks, whether in stock market or projects, we can expect a higher return. Thus, determining a project’s risk-adjusted discount rate through the CAPM, enables us to estimate and simulate the Net Present Value of the project. If a firm is intending to make an investment, it can estimate its risk, then the firm apply the discount rate to the cash flow that the firm expect from the investment; the firm should use the risk factor calculated from the CAPM equation as the discount rate. It is advisable to use CAPM to estimate NPV using the cost of capital as the discounted rate and thereby to choose the most potential project that would maximise the firm’s value. According to Jagannathan and Meier(2002), some of the economists holdthe view that the usage of a hurdle rate which is higher than the cost of capital, together with conventional NPV calculation techniques, would assist a firm to consider the possible value of the option to wait.However, in real practice, it is observed that there is lack of correlation between betas and hurdle rates. Errors in the estimation of cost of capital would not much affect firms having substantial real option components. Evidences show that the estimation of NPV using CAPM has been helping organisations because this model considers a wide range of factors while calculating the NPV. In addition to the estimation of NPV, the CAPM assists an investor to determine the required rate of return. Furthermore, no other potential theories have been developed yet as an alternative to CAPM. Conclusion In total, CAPM has greater influence on modern investment analyses despite the harsh criticisms the theory has been facing. This theory is used to estimate the net present value of a project using cost of equity. As per CAPM principle, an investment would be feasible if the NPV is positive, and a negative NPV value does not support the investment decision. It is advisable to use CAPM for the estimation of NPV of a project as it takes different project elements into account. References Civil Aviation Authority, November 2001, ‘Economic regulation and the cost of capital’, pp. 1-33, Viewed 14 November 2011, Huberman, G & Wang, Z August 2005, “Arbitrage pricing theory”, Federal Reserve Bank of New York: Staff reports, no. 216, pp. 1-18, Viewed 14 November 2011 Jagannathan. R & Meier, I 2002, ‘Do we need CAPM for capital budgeting?’,Resource Library, Viewed 14 November 2011, Mabrouk, HB &Bouri, A June 2010, ‘The quarrel on the CAMP: A literature survey’, Interdisciplinary Journal of Contemporary Research Business, vol.2, no. 2, pp. 265-305. McCrie, RD 2001, Security & Operations Management, Butterworth-Heinemann, US. Pratt, SP & Grabowski, RJ 2010, Cost of Capital in Litigation: Applications and Examples, John Wiley & Sons, New Jersey. Puxty, AG, Dodds, JC & Wilson, RMS 1988, Financial Management: Method and Meaning, Van Nostrand Reinhold, London. Roll, R & Ross, S December 1980, ‘An empirical investigation of the arbitrage pricing theory’, The Journal of Finance, vol. 35, no. 5, pp.1073-1103. Shanken, J 1982, ‘The arbitrage pricing theory: Is it testable?’,The Journal of Finance, vol.37, no.5, pp. 1129-1140. Slee, RT 2011, Private Capital Markets: Valuation, Capitalization, and Transfer of Private Business Interests, John Wiley & Sons, New Jersey. Read More