Capital Asset Pricing Model - Essay Example

?Capital Asset Pricing Model Introduction The Capital Asset Pricing Model (CAPM) was initially developed by Harry Markowitz in 1952. The model was later on modified by other practitioners including William Sharpe. This theoretical framework is widely used to describe the relationship between expected rate of return and possible risk elements while addressing the pricing of risky securities. This concept holds that an investor’s time value of money and level of risks must be considered while rewarding him. These factors are generally computed using a risk measure called beta. Although the CAPM is widely used for anticipating the feasibility of an investment decision, this model has a number of corporate applications also. This model has been heavily criticised and debated over the past decades, and many of the economists are of the opinion that this framework is not adequate enough to assess various risk factors comprehensively. However, none of the opponents could introduce a potential alternative to this concept till date. This paper will critically analyse the applicability of the CAPM in corporate finance applications in the context of modern business environment. Corporate applications of CAPM Hillier et al (2008, section 5.1) provide a detailed view of the corporate applications of the capital asset pricing model. Through a well integrated theoretical concept and empirical evidences the authors give readers an easy understanding of the applicability of CAPM in corporate finance. Through this section, the authors address the misconception that the CAPM theory is applicable only to investment purposes. The application of capital asset pricing model together with mean variance analysis is greatly supporting corporate managers in decision making process today (Grinblatt & Titman 2003, p. 132). The author argues that a manger is most likely to lose his job if his organisation is continuously struggling with declining stock prices (ibid). Hence every corporate manger is forced to improve the firm’s stock prices at any cost. For this, the manager needs clear understanding of the different elements that determine share value. Such knowledge would greatly assist corporate managers to determine what actions would improve the stock value and thereby serve the interest of stockholders and directors. For instance, the combined application of CAPM and mean variance analysis may help firms to hedge their risk elements to a great extent and “diversify their portfolios of real investment projects” (Grinblatt & Titman 2003). The CAPM model also benefits multinational corporations to scrutinise their capital expenditure decisions. Management theories and historical evidences clearly indicate that thoughtless capital expenditures would lead to corporate failures. Top executives are extremely concerned with the firm’s capital expenditure strategies as they determine the organisation’s levels of sustainability. At this juncture, CAPM assists regulators to frame their capital expenditure strategies by focusing on various factors affecting capital expenditure. This concept is also useful for financial managers to arrive at reasonable conclusions on how to value real assets. Although many of the critics claim that CAPM model cannot be used for valuing real assets, majority of corporations are still cantered on this model. However, scholars like Lee et al (2009) strongly believe that CAPM can be very useful in real asset valuation. While analysing the historical growth phases of CAPM, it seems that corporate managements have been using this model in their all areas of financial analysis and planning since the development of this concept. Scholars opine that capital budgeting is one of the major corporate applications of the CAPM. If it is possible to predict the systematic risk associated with a project accurately, then the CAPM can be applied to compute the risk adjusted discount rate which is essential to compensate the organisation for the risk elements of the project. “If the sum of the estimated cash flows discounted by the CAPM-calculated required rate of return is positive, then the firm should undertake the project” (Lee et al 2009, p.303). Through this method, CAPM can be effectively employed to manage the uncertainty of a project. The capital asset pricing model has a great influence on the valuation of the entire organisation (ibid). Lee et al continue that this model has considerable significance on merger analysis as it can impact the overall firm valuation. Financial experts have proven that the inclusion of securities would significantly reduce portfolio risk, given the condition that returns of those securities are not perfectly correlated (ibid). This principle is applicable on mergers between organisations. Evidently, many of the growing corporations tend to choose merger to expand their operational areas and territories as merger is the most cost effective business expansion strategy. However, the corporate management has to clearly evaluate the potentiality of the targeted firm in order to make sure that merger would bring potential advantages to the firm over its competitors. The CAPM model can play a crucial role in assessing the potentiality of a firm and thereby the feasibility of the proposed merger. The potentiality of a merger decision can be analysed with the application of the CAPM form of analysis managed by the ‘value additivity principle’ (VAP). The VAP reflects that any set of income streams acquired by investors holds the same value in the market under an equilibrium condition; and this value will not be affected by the way the set of streams are divided or combined into the equity stream of any of the firms under consideration (ibid). In short, this model greatly assists firms to deal with business expansion through mergers effectively. The CAPM model can be best applied to analyse the impacts of an organisation’s dividend policy on its stock prices and shareholder values (Gallagher & Andrew 2007, p.237). This application is possible by including a dividend term and taking its effects into account. Corporate evidences have shown that a firm’s ineffective dividend policy would adversely affect its market stock prices and thereby shareholder interests. An over distribution of dividend would probably decrease the level of reserves that is necessary to effectively meet unforeseen contingencies and other business risks (Basu 2009, p.8.8). Such a situation may threaten the operational flexibility and long term sustainability of the organisation. This in turn would adversely affect the economic interests of stockholders as well. At the same time, an under distribution of dividend would directly dissatisfy shareholders as this strategy does not safeguard their short term financial interests. Hence, it is obvious that both under and over distribution of dividend will not meet the shareholder interests, and naturally the organisation’s stock prices may decline. In order to avoid such troublesome situations, organisations have to develop a well structured dividend policy that would equally meet stockholder interests and management interests. Therefore, the CAPM can be very effective in identifying the potential level of business reserves and setting a comprehensive dividend policy acceptable to all. According to another view, this theoretical model can be best applied for “understanding how debt financing affects the risk and the required return of a share of stock” (Grinblatt & Titman 2003, p.132). Financial flexibility is appeared to be the most significant factor determining the appropriate level of corporate debt. As discussed earlier, CAPM can evaluate the financial flexibility of a firm by considering various macroeconomic elements. It is clear that the careless debt financing would cause organisations to lose control over their business. While an organisation finance its ventures through huge debts, it may find difficulties in repaying the debt if the planned venture does not bring anticipated rate of returns. Under such circumstances, the firm would be forced again to meet its working capital requirements through debt financing. Evidently, a business organisation cannot survive for a long time on the strength of debt financing strategies. Therefore, CAPM is really beneficial for modern organisations to assess their financial flexibility. It will also help to determine the proper amount of debt that would provide the firm with greater level of certainty or minimum level of risks. However, many practitioners oppose the application of capital asset pricing model in debt financing, arguing that the model does not consider every financial variable that influences the firm’s financial flexibility. CAPM is highly applicable “in testing the efficient market hypothesis” in corporate finance (Lee et al 2009, p.303). The concept of efficient market hypothesis (EHM) assesses the performance of corporate managers in maintaining fully disclosed financial statements. It also helps stakeholders to evaluate the management’s efficiency by observing stock price fluctuations. Furthermore, the EHM aids the board of directors to assess management performance and thereby determine the level of compensation to executives with respect to share price. For the effective operation of a stock market, information disclosure is necessary because different stakeholders including investors, employees, and third parties cannot analyse the feasibility of an organisation unless the firm fairly discloses its financial statements. In short, EHM even affects the overall economic growth of a country. Therefore, the testing of efficient market hypothesis is a valuable corporate application of capital asset pricing model. Rubinstein (2006) describes that CAPM can also be used to rate securities and to compute their risk adjusted equilibrium price. For this purpose, the CAPM has to be initially converted into price variables; and this model is useful to compare between alternative projects under uncertainty and hence to choose the most potential option (ibid). The capital asset pricing model is a best measure to form asset expansion decisions as this framework can accurately identify the firm’s potential to grow. It is obvious that the development of asset expansion projects is essential for business growth, and hence the management needs to take such decisions thoughtfully and on time. According to another opinion, this theoretical model can be effectively employed to determine the capital structure by identifying the best combination of debt, equity, and hybrid securities to finance the corporation’s assets (Swanson et al 2003). Although majority of the corporate applications of this model are still debated, no other potential alternative approaches are there to replace CAPM. Conclusions In total, the capital asset pricing model (CAPM) is of great value in a wider range of corporate applications ranging from simple project investment analysis to merger analysis. The model can be best applied to evaluate the financial flexibility in order for setting long term objectives. In addition, this method can play a central role in determining a firm’s capital structure and developing asset expansion decisions. Testing efficient market hypothesis is one of the major applications of CAPM in corporate finance as EMH. Finally, this concept is applicable to dividend policy analysis also; and therefore it helps the firm to ensure better stock price levels and greater stockholder satisfaction. Undoubtedly, the CAPM has greater influence on modern corporate decisions despite the criticisms the theory has been facing. References Basu, SK 2009, Fundamentals of Auditing, Pearson Education India, India. Grinblatt, M & Titman, S 2003, Financial Markets and Corporate Strategy, Tata McGraw Hill, New Delhi. Gallagher, TJ & Andrew, JD 2007, Financial Management: Principles and Practice, Freeload Press, USA. Hiller, D et al 2008, Corporate Finance: with Connect Access Code, McGraw Hill Higher Education, US. Lee, AC et al 2009, Financial Analysis, Planning & Forecasting: Theory and Application, World Scientific Publishing, Singapore. Rubinstein, M 2006, A History of the Theory of Investments: My Annotated Bibliography, John Wiley and Sons, New Jersey. Swanson, Z et al 2003, The Capital Structure Paradigm: Evolution of Debt/Equity Choices, Greenwood Publishing Group, USA. Read More