The Relevance of the Capital Asset Pricing Model to a Company Seeking to Evaluate its Cost of Capital - Essay Example

 A Discussion of the Relevance of the Capital Asset Pricing Model (CAPM) to a Company Seeking to Evaluate it’s Cost of Capital. Introduction In finance and the business world, the cost of capital represents the costs involved in terms of obtaining money, which also can be stated as the return that is required in order to meet the expense of underwriting a project (investopedia, 2007). Krausz and Pava (1995, p. 17) tell us that the Capital Asset Pricing Model (CAPM) represents a foundation of finance as it assumes investors are interested in two important facets as represented by “…the mean and variance of portfolio returns”. This study will look into the Capital Asset Pricing Model using Virgin Media as an example of the manner in which the CAPM is relevant for a firm looking to determine its cost of capital. Understanding CAPM The Capital Asset Pricing Model was devised by William Sharpe to calculate as well as explain “…the expected rate of return on any asset … (that) …can be written as the risk-free rate of interest plus the asset’s normalized covariance with the market times the difference between market's expected rate of return and the risk-free rate” (Milne, 1995, pp. 5-6). Under financial theory CAPM is a model that shows assets returns concerning principle in conjunction with econometric models (Milne, 1995, pp. 5-6), and is represented by the following formula (Burton, 1998, pp. 21-22): CAPM is calculated using he beta as it provides a measurement of a stocks volatility in terms of its movement comparison with the overall stock market (Burton, 1998, pp. 21-22). The above means that when a company’s share price moves in tandem with the market, with the beta of a stock is represented by 1, and a 15% movement indicated as 1.5 (Burton, 1998, pp. 21-22). Foster (1986, p. 337) provides a summary of the two assumptions present in the Capital Asset Pricing Model as represented by “1. Two statistics, the mean and variance, are sufficient to describe investor preferences over the distribution of future returns on a portfolio. 2. Investors prefer higher expected returns to lower expected returns for a given level of portfolio variance, and prefer lower variance to higher variance of portfolio returns for a given level of expected returns". Corporate finance managers utilise CAPM to determine the estimated discount rate that is connected to a project under consideration (Ferran, 1999, p. 12). In conjunction with the foregoing, CAPM is used as a means to measure the systematic risk present in equity investment projects (Megginson, 1997, Pp. 107-123). Houthakker and Williamson (1996, pp. 150-162) elaborate on the preceding by advising that CAPM provides finance managers with the understanding of the return rate needed on a project though referencing the risk free return rate available, along with the premium investors need to be compensated for to override the risk in supplying the money. The foregoing is termed as systematic risk (Houthakker and Williamson, 1996, pp. 150-162). The foundational comparator used is government securities, which represent the soundest form (Ferran, 1999, p. 58). An Application of CAPM / Virgin Media To illustrate the above Modigliani and Miller (Suvas, 1992) bring forth the Weighted Average Cost of Capital (WACC), which is the common manner of arriving at the cost of capital. To provide an example of how this is arrived at, Virgin Media will be used. The WACC is calculated by looking into the capital cost for each component via their relative weights (Barber, 2005). In looking at the company for their accounting period from 2007 / 2008, the following factors were considered (Value Based Management, 2008): The market value of the debt = £7,655,600,000 The market value of equity = £7,874,400,000 The cost of debt = 7.9% The corporate tax rate = 30% The Cost of Equity is = 14.03% The WACC for the above is thus represented 9.84% Swanson et al (2003, pp. 16-17) tell us that the market value of a company’s debt is usually hard to arrive at as few firms carry all of their outstanding obligations in traded forms such as bonds. From the Balance Sheet of Virgin Media it was found the company for the period had a debt of £7,655,600,000, with its outstanding shares totaling 328,100,000 (finance.aol.com, 2009). The average share price was £24.00 thus representing a market equity total of £7,874,400,000, with the UK tax expense represented as 30% (worldwide-tax.com, 2009), and the interest expense as £514,200,000 (Virgin Media, 2007). To arrive at the cost of equity, the Capital Asset Pricing Model was used that provided the information concerning the risk and the expected return that is shown in the following formula (Bartholdy and Peare, 2000, Pp. 4-5): Kc   =   Rf   + beta  x ( Km - Rf ) where Kc is the risk-adjusted discount rate (also known as the Cost of Capital); Rf is the rate of a "risk-free" investment, i.e. cash; Km is the return rate of a market benchmark, like the S&P 500. The United States S&P 500 was used as the benchmark which represented a 12%, with the risk free investment representing government bonds a 5%, and the beta of Virgin Media was 1.29 thus representing 14.03% as the cost of equity (finance.aol.com, 2009). Conclusion This examination as sought to explain the significance of the Capital Asset Pricing Model through explanations of its function and components that include understanding the Weighted Average Cost of Capital. The latter is important as it represents a means of understanding the minimum returns applicable to a project for the correct utilization of a firm’s cash. The significance of the preceding is that such can have a dramatic impact on how a company utilises its funds as well as the competitive performance in terms of future debt taken on that might becoming an impediment to underwriting future projects. As a result, financial managers must understand the implications of the Capital Asset Pricing Model and the varied investments and or capital allocations a firm is considering as each project must be able to meet its return targets as the risk of sacrificing future targets if not met. Investments taken on by a company that do not meet their objectives drain a company of revenues and cash appreciation that is needed to fuel future growth. References Burton, J. (1998) Revisiting the Capital Asset Pricing Model. May / June. Dow Jones Asset Manager Barber, J. (2004) Cost of Capital with Flotation Costs. Vol. 43. Quarterly Journal of Business and Economics Bartholdy, J., Peare, P. (2000) Estimating Cost of Equity. Aarhus School of Business. Aarhus, Denmark Ferran, E. (1999) Company Law and Corporate Finance. University Press. Westport, CT, United States finance.aol.com (2009) Virgin Media. Retrieved on 16 November 2009 from http://www.worldwide-tax.com/uk/uk_taxes_rates.asp http://finance.aol.com/quotes/virgin-media-inc/vmed/nas Foster, G. (1986) Financial Statement Analysis. Prentice Hall Books, Englewood Cliff, N.J., United States Houthakker, H., Williamson, P. (1996) The Economics of Financial Markets. Oxford University Press, New York, New York Investopedia (2008) Beta. Retrieved on 16 November 2009 from http://www.investopedia.com/terms/b/beta.asp investopedia (2007) Capital Asset Pricing Model (CAPM). Retrieved on 16 November 2009 from http://www.investopedia.com/terms/c/capm.asp Krausz, J., Pava, M. (1995) Corporate Responsibility and Financial Performance: The Parados of Social Cost. Quorum Books. Westport, CT, United States Megginson, W. (1997) Corporate Finance Theory. Addison Wesley, New York, New York, United States Milne, F. (1995) Finance Theory and Asset Pricing. Oxford University Press. Oxford, United Kingdom Suvas, A, (1992) Cost of Equity Capital Redefined. Vol. 31. Quarterly Journal of Business and Economics Swanson, Z., Seetharaman, A., Srinidhi, B. (2003) The Capital Structure Paradigm: Evolution of Debt/Equity Choices. Praeger Publishers. Westport, CT, United States Value Based Management (2008) WACC – Weighted Average Cost of Capital. Retrieved on 16 November 2009 from http://www.valuebasedmanagement.net/methods_wacc.htm Virgin Media (2008) Form 10-k for Virgin Media. Retrieved on 16 November 2009 from http://library.corporate-ir.net/library/13/135/135485/items/327171/F8AB0023-58C4-4612-94B6-C0F6EF4AD103_Virgin%2010k%20no%20banners.pdf worldwide-tax.com (2009) U.K. Tax Laws and Tax System. Retrieved on 16 November 2009 from http://www.worldwide-tax.com/uk/uk_taxes_rates.asp Read More