Evaluation of The Capital Asset Pricing Model (GlaxoSmithKline) - Essay Example

?Evaluation of The Capital Asset Pricing Model Contents Evaluation of The Capital Asset Pricing Model Contents 2 Part I- Evaluation of the Capital Asset Pricing Model 3 CAPM Assumptions 3 CAPM Limitations 3 Part II GlaxoSmithKline Risk and Return Analysis 4 About the Company 4 Dividend per Share Paid by GSK 4 Estimate Beta of GSK 5 Using CAPM to Estimate Cost of GSK Equity and Share Price 7 Using Dividend Valuation Model to Estimate GSK’s Share Price 7 Explanation and Comments 8 Part 3 9 Evaluation of the company’s strategy and manager’s role in diversifying shareholders’ risk 9 Factors to be considered while undertaking international investments 10 Methods of solving the issues related to international investment 13 Reference 14 Part I- Evaluation of the Capital Asset Pricing Model Capital Asset Pricing Model is the theory which links the risk and return of the concerned asset. It is used to determine the price of the risky securities. In the year 1964 based on the article ‘Journal of Finance,’ William. F. Sharpe proposed the idea of the CAPM model (Kurschner, 2008, p.2). This model generated the idea of beta, that is, the risk of the specific stock. The CAPM model thus is mainly used by firms for estimating the cost of equity. CAPM Assumptions The CAPM model makes some assumptions for calculating the price of the securities which are risky. These assumptions are as follows : The market is efficient and perfect. The information regarding the market is easily available to all the investors. No single investor can influence the stock price change of the market. As the market is efficient there is no transaction cost, no taxes (kapil, 2011, p.168). The investors are risk averse in nature. All the investors have same expectation about the return from the market. It is also assumed that the assets are perfectly liquid and they are divisible infinitely. It means the investor can buy or sell any amount of stock. It is also assumed that all assets can be sold or bought in the market by the investors including the human capital. At the risk free rate the investors can borrow or lend unlimited amount and they can expect risk free rate of interest from the funds. Unlimited short selling is allowed as per the assumption of CAPM model. The investors are concerned with a single period price of asset and the mean and variance of the concerned asset (Elton et al, 2009, p.283). CAPM Limitations CAPM model is criticised because of the number of assumptions it makes. It is assumed in the model that the market is efficient which in reality it is not. The information regarding the market is not readily available to the investors. There is also the transaction cost of trading and the taxation cost which the model does not take into consideration. In the model it is assumed that the investors are interested only for a single period of change in the asset pricing. But in reality when they invest they do the fundamental analysis of the stock which means they analyze the historical value of the asset taking a long period into consideration. The beta of the asset changes over the period, it is not stable as assumed by the CAPM model. The investors are not also risk averse in nature and also it is not possible that the assets are divisible entirely. The relationship of beta and return is weak practically (Damodaran, n.d., p.13). It is also a factor that the firm may change in the period for which the estimation is made. Instead of these limitations, CAPM model provides the quantitative and logical tool for measuring the risk and return relationship of the asset or the portfolio. Part II GlaxoSmithKline Risk and Return Analysis About the Company GlaxoSmithKline, a company of the pharmaceutical industry was founded in the year 2000 and listed in the London stock exchange and the New York Stock Exchange. The company is a constituent of FTSE 100 index. The company is based in London and in terms of revenue it is the third largest company in the world. The company’s business is spread throughout the world. The long term strategy of GSK is diversifying the global business, simplify the operating model and provide value added product to the customers. Dividend per Share Paid by GSK Dividend per share paid by GlaxoSmithKline is as follows: Data Source: (MSN Money, 2011) Estimate Beta of GSK Figure: FTSE index and Market Return Source: (Yahoo Finance, 2011) GlaxoSmithKline is the constituent of FTSE100 stocks. The index over the past 11 years is taken for calculating the market return. Figure: Historical Prices of GlaxoSmithKline and the market return Source: (Yahoo Finance, 2011) The asset price of GlaxoSmithKline is taken for calculating the market return of the stock. Var(Rm) = 0.304684251/(10-1) = 0.034 Cov (Rm, Ri) = 0.132038653/ (10-1) = 0.01467 The estimated beta of GSK is: ? = Cov (Rm, Ri)/ Var(Rm) = 0.01467 / 0.034 = 0.4314 The beta of GSK is 0.43 which means the stock is a defensive one as the beta is less than 1. The risk of the stock is lower which means the return of the stock is also lower. The ? of the stock is lower which means that when the market would rise by 10% then the stock price of GSK would increase by 4.3% and when the market would lower by 10% then the stock return would decrease less, it would be 4.3%. Using CAPM to Estimate Cost of GSK Equity and Share Price Ke= Ri =Rf + ? (Rm-Rf) It is assumed that Rm =12% Rf= Risk free rate as the current rate of UK government bond’s 10 years maturity = 3.75%. (Bloomberg, 2011). The cost of equity of GlaxoSmithKline is = Ke = 3.75% + 0.4314 (12%-3.75%). = 7.30 The estimated Rm = 1.14%. It shows very low market return than the assumed. So the cost of Equity of GSK is = 3.75% + 0.4314 (1.14%-3.75%) = 2.13% The beta of the stock is low so it would also return low. The return of the stock is 2.13% which is lower than the risk free rate of 3.75%. It is the recession period which has affected the market. The company’s beta is low which implies that the company is risk averse in nature. Estimated price by the CAPM model: Po= (Capital Gain or Loss + Dividend) / Ri = P1-Po+Dividend/ Ri = (1275-1325) + 65/ 2.9% = 517.25 The estimated price is 517.25, which is much less than the actual price 1275 in the year 2010. Using Dividend Valuation Model to Estimate GSK’s Share Price In the dividend valuation model it is assumed that the dividend of a company increase in a constant rate g. The price of a stock also can be measured by this model. Po= do (1+g)/ (Ke-g) g= (Last Dividend/ First Dividend) ^ (n-1) -1 = 0.079 = 7.9% It is found that the cost of equity of GSK is lower than the rate of dividend. The cost of equity is 7.3% and the growth of dividend is 7.9%. So the constant growth model can’t be used. In this scenario it is assumed that the dividend would not grow that means g=0. So the asset price would be Po=do/Ke = 65/7.3% = 890.41 The estimated price is 890.41, which is also lower than the actual price 1270 in the year 2010. Explanation and Comments The estimated price of the stock is less than the actual price of the stock of GSK, which indicates the stock is overvalued. It means the investor is willing to pay more prices for the stock than its actual value. According to the CAPM model only beta affects the security prices but in reality this doesn’t happen as the recent financial crisis is also the factor which affects the prices. The dividend valuation model depends on more than one factor. The dividend of the company increased over the five year period which is positive and attractive factor for the investors. The increment of dividend increases the competitive advantage of the company but the question arises that whether the company will continue to pay more and more dividend or they should invest their earnings in further investment. As their share price is overvalued so they should take care about this factor. Part 3 Evaluation of the company’s strategy and manager’s role in diversifying shareholders’ risk Every company at some or the other point of time introduces many types of strategic steps in order to have a competitive advantage and achieve a better market position. Sometimes to have the advantages of the synergies of the new sectors many companies diversify themselves in new areas. Again growth is also an important factor for every company and expansion is an important aspect of growth. Companies can expand themselves both internally and externally. During the course of a business, companies often acquire new plant, machinery, equipment etc. They also adopt new techniques of production and some times introduces new product line to gain more competitive advantage. Through all these steps the company expands itself internally that is by bringing changes into its internal processes. As mentioned earlier companies also diversify themselves in many other sectors or markets to take advantage of the sunshine areas and have the synergetic effects. This can be done with the help of external expansion in the form of merger and acquisition. Merger can be defined as combining two businesses to form one single business in such a way that the liabilities and assets of the merging companies become the liabilities and assets of the merged company. Mergers can be done through absorption or through consolidation like the merger of Tata fertilizer and Tata Chemicals was done through absorption where as HCL Ltd was formed through consolidation. Mergers are mainly of three types, namely horizontal merger, vertical merger and conglomerate merger. Horizontal merger takes place between two companies that are operating in the same sector. This type of merger is mainly done in order to achieve more market share whereas vertical merger is done between two firms that are operating in two different production stages. Conglomerate merger can be done between companies that are operating in different unrelated businesses. Acquisition on the other hand means totally taking over the management and control of the acquired company by the acquiring company. Mergers and acquisition helps to accelerate the growth of the company. It also helps to improve the overall profitability and enables the company to take advantage of the synergy and economies of scale. GlaxoSmithKline is a drug manufacturing company which is highly reputed in the sector of medicines. It has good capital base. GSK wants to diversify itself into a completely new sector of carbon absorption. The management could initiate this diversification by either entering into conglomerate merger or complete acquisition. Such type of diversification will not only help in the company’s growth but will also help to reduce the risk as the cash flows of the original business and that of the acquired business will be unrelated (Business Portal of India, n.d). It is assumed that the company is operating in an efficient market which means that all the relevant information about the stock will be reflected in its price. Thus, the ambitious news of the company’s diversification in a new and demanding sector would have a positive impact on the stock’s price. Moreover, as mentioned earlier that the diversification of business would help the company to reduce the company specific risks which is also known as the unsystematic risk. Thus diversification would help GSK to unsystematic risk to an extent. The main aim of the manager is to maximize the shareholders’ wealth. But, as cited by Brealey and Myers a conflict arises between the interests of the shareholders and the managers which are to an extent similar to that of the problems between principle and the agent. During the unfavourable situations mangers can take some extreme risky decisions which can be fruitful to the business as well as to them but the shareholders might not be ready to risk their money (Brealey and Myers, 2004, p.8). As per the CAPM, shareholders can minimise unsystematic risk of their investment by diversifying their investment portfolio. This could be done either investing in other stocks or pooling up the money into a number of securities through mutual funds. Shareholders are interested in minimising the systematic risk but the management would be concerned of the total risk which cannot be eliminated through diversification. Moreover, international diversification will attract other costs and will expose the company to market risks, exchange rate risk, interest risk, inflation etc which could severely affect the company’s health. In case of GSK’s diversification, unrest among the local community who will be severely affected due to the venture could pose severe operational problems in future. Though the company has the political support but the support of the local community is inevitable for an organisation’s operation. Hence, it can be said that the shareholder’s risk should not be diversified by the managers. Factors to be considered while undertaking international investments Nowadays many companies invests in the foreign shores to take advantage of the off shore markets. This provides the companies to exploit the prospects of the emerging markets. International investments also help the companies to find new markets for their existing products whose demand in the home country has become saturated. The companies have to consider the following few important factors while under taking any international investment:- Cost of production: Cost of production is one of the important factors which should be considered by the company while making any international investment. Whatever be the type of business be, the company will require some factors of productions to operate in the foreign land like human resource, raw material (in case of a manufacturing company), land, building, transportation etc. Before deciding on the international investment, the company has to analyse the costs of various factors of production. If the cost of production is higher in the foreign country, then the international investment won’t be beneficial to the company (Cherunilam, 2008, p.507). Economic factors: The international investment decisions are also influenced by many economic factors like gross domestic product of the country, the rate of inflation, the income level of the people, the level of disposable income, population, rate of industrialization etc. If there is high rate of inflation or the gross domestic product of the country is comparatively much lower than that of the home country of the company, then the company won’t be able to earn satisfactory return on international investment (Cherunilam, 2008, p.507). Political factors: Political factors should also be considered while making an international investment. The country which has political stability, does not suffer from external aggression, and is secured in terms of providing security to properties and lives. It provides n number of profit earning opportunities and is hassle free in terms of industrial policies, immigration policies and other polices of employment. At the same time it does not make the company suffer from double taxation and other such things which are considered highly favourable for international investment as it promotes the industrial activities (Cherunilam, 2008, p.507). Interest rates: Apart from economic and political factors, another important aspect of the international investment is interest rates. It has been seen that the country which has higher interest rate is considered favourable than the country where interest rate is low. A higher interest rate provides an added advantage to the investing company to earn a higher return. Government policies: Government policies are a very important factor which should be analysed while making any international investment decision. The policies of the government regarding the various taxation policies like taxation on business profits, tax on dividends, policies regarding the special economic zones, policies regarding blocked funds have to be considered. Apart from these policies, the various policies regarding the foreign investment, foreign exchange control, monetary and fiscal policies are very important to be considered while making international investment (Cherunilam, 2008, p.507). Profitability: International investments involve large amount of cash flows. Therefore, the profitability criteria regarding the investment should be properly analysed and assessed. Apart from the various risk factors which any investment is prone to, international investment is also prone to the risk of fluctuating exchange rate. The profitability of a company gets severely affected due to the exchange rate. Thus the profitability of the international investment should be analysed from various aspects to avoid any type of loss in future (Cherunilam, 2008, p.507). Market Size: Another important factor which should be analysed while making an international investment is the market size of the target market in which the investment would be made. The market in which investment would be made should have enough demand for the product of the investing company. Moreover, the dominant market leaders should be analysed to assess the competitive advantage of the investing company (Cherunilam, 2008, p.506-507). Consumer’s preference: The consumer’s taste and preference is very important for every investor who is entering into a new market. In case of international investment, this aspect becomes more important for assessment as the tastes and preferences of the consumers differs from region to region. Moreover the cultural beliefs and customs should also be analysed to identify whether the target customer in the new country would prefer the product or not (Cherunilam, 2008, p.506-507). Social amenities: The social amenities like schools, colleges, universities, hospitals etc are also important while making an international investment (Cherunilam, 2008, p.506-507). Methods of solving the issues related to international investment There are various issues related to the international investment like taxation policies, double taxation agreements, inflations, exchange rate fluctuations, profitability etc which have been discussed in details in the previous section. Some of the issues related to cost of production, inflation and taxation policies can be resolved by making various studies on the taxation policies and economic conditions of the foreign country. The profitability of the investment can be analysed with the help of various capital budgeting techniques. Companies can compute the net present value to assess the financial viability of the investment. Net present value can be defined as the excess of present value of cash inflows over the present value of cash outflows. If the net present value of the projected business is positive then the company should initiate the investment. Apart from net present value technique, the company can also compute the internal rate of return to assess the financial viability of the project. If the internal rate of return is more than the required rate of return then the company should accept the project otherwise should not undertake the project (Brigham and Houston, 2009, p.371-375). Moreover, companies who want to undertake international investment should also conduct sensitivity analysis of the investment proposal. This will provide an insight to the management about the future prospects of the investment if various factors related to the investment changes from that of the projected ones. Moreover, the company should do a variety of CSR (corporate social responsibilities) activities which would help it to achieve goodwill in the foreign land. Reference Bloomberg. (2011). Markets-U.K. Government Bonds. [Online]. Available at: http://www.bloomberg.com/markets/rates-bonds/government-bonds/uk/. 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