Principles of Corporate Finance - Essay Example

? Capital Asset Pricing Model Capital Asset Pricing Model Introduction This report would make the readers understand what Capital Asset Pricing Model (CAPM) is and how it is used for decision making by the corporate sector. Also, his report would also entail the application of CAPM model with respect to three-factor model of Fama and French. Capital Asset Pricing Model (CAPM Capital Asset Pricing Model (CAPM) is considered to be one of the most commonly used financial models used in the industry to determine the impact of risk on return from a certain investment (Brealey, Myers, & Allen, 2011). William Sharp introduced the model in 1964.Corporate sector uses CAPM in order to identify the required rate of return on assets deployed to achieve organizational objectives. In order to effectively implement CAPM, the corporate sector is required to take into account, the sensitivity of the assets to the symmetric or market risk. The symmetric risk is identified within CAPM equation as beta (?). Keeping in view the logical relationship of CAPM with business related decisions, beta (?) helps the corporate sector to determine the investor’s cost of capital equity acquired. Other factors that CAPM takes into account are expected return of market on the assets deployed and the expected return on risk-free assets deployed (Kurschner, 2008; Fama & French, 1995). As corporate sector uses CAPM for placing a price tag over its securities and other elements in the portfolio, the baseline for developing a formula for CAPM starts with security market line (SML). When the formula is employed on the costing of assets, the outcome reflects how the market would perceive the costing of individual securities with respect to the security risk class. In this manner, reward-to-risk ratio can be calculated. Once, any deflation or inflation has occurred in expected rate of return for securities, it can be viewed as being the outcome of the variations observed in beta (?) coefficient. As a result, the reward-to-risk ratio of securities becomes equal to market reward to risk ratio, which provides this equation: E (Ri) – Rf / ?i = E (Rm) –Rf In this equation, market risk premium is mentioned by market reward-to-risk ratio. A slight shuffle in the above equation in order to attain E (Ri) would give the following result: E (Ri) = Rf + ?i[ E (Rm) – Rf] In this equation, E (Ri) denotes the expected capital asset return and Rf denotes the interests arising from the acquisition of Governmental bonds. These bonds possess risk free rate of interest. Moreover, ?i denotes the sensitivity of the expected retune on excessive assets and can be demonstrated as: ?i= Cov (Ri,Rm) / Var (Rm) In this equation, Rm denotes the expected return of the market on the assets deployed and Rm-Rf denotes the market premium. When the equation is reshuffled and restated as to achieve the risk premium, it would give the following resultant: E (Ri) – Rf = ?i [E (Rm) – Rf) Hence, the result reveals that individual stock risk premium is equivalent to the premium on the market portfolio. To achieve size premium and specific risks related to the deployment of individual assets, CAPM could be altered as this is beneficial for financiers of private sector corporations possessing a non-diversified portfolio. This equation is considered as the fundamental equation for applying CAPM. E (Ri) = Rf + ? (RPm) + RPs+ RPu In this equation, E (Ri) refers to the required rate of return on security, whereas Rf denotes the risk-free interest rate on individual assets deployed. On the other hand, RPm refers to the premium acquired on general market risk and RPs is the risk premium on small size assets deployed. Lastly, RPu refers to the risk premium earned due to company specific risk factors (Fama & French, 1992). In order to make effective use of CAPM, one must understand the assumptions that serve as the pillars for developing this model. These are as following: 1. Investors in securities are making investments for one year in order to increase utility wealth, as these securities are selected on the basis of varying returns. 2. Funds are borrowed to or lend by investors on a risk free rate of interest. 3. Financiers as identical subjective estimates perceive the mean, variance, and covariance of the security selected. 4. The financial securities acquired are competitive to alternate securities available in the market. 5. All financiers are price takers. 6. All financiers are required to acquire fixed amount of securities. 7. The securities acquired are liquid and can be marketed with incurring transaction costs, and 8. The securities acquired do not possess any tax on them (French, 2003). CAPM for Corporate Decision Making When corporations strive on developing a strategic portfolio and implement planning procedures for problem solving, they have to be critical on deciding on two aspects. The first decision is regarding the expansion or reduction of the portfolio size (Ross, 1977; Mossin, 1966). This is done by evaluating the performance of each business and deciding which business needs to be retained and which business should be eliminated from the portfolio (Rubinstein, 2006). The second decision is more critical for the survival of a corporation as it includes decisions regarding further investments to be made on the businesses, which are retained during the process of first decision-making (Ross, 1978). At this stage of decision-making, CAPM model enables the corporation to increase the size of the expected value for the corporation’s offered common stock in the market. The equation for expected value of common stock offered by the corporation is expressed as following: V = R- ?rm? / i Where I is the risk-free interest rate. To understand CAPM more thoroughly, the above-mentioned equation helps corporations to ease down strategic planning decisions. The parameters over which the corporation may have utter control are given as following: 1. “The rate of return (R) 2. Standard deviation for the rate of return (?) 3. The relationship between the coefficients of corporation’s rate of return and the market rate of return (rm)” (Sharpe, 1964). The equation stated above clearly reflects that the management of a particular corporation should focus more on investing in long term strategies which results in significantly increasing corporation’s rate of return and a significant decrease in standard deviation of corporation’s rate of return and coefficients of the corporation’s rate of return and the market rate of return (Naylor & Tapon, 1982). Three Factor Models of Fama and French The CAPM is considered as being the most fundamental model used by financiers of corporations around the world. But Fama and French’s (2006) criticizes the actual implementation of CAPM and its ability to project returns earned by the corporation on investing in stocks. Moreover, Fama and French also suggest that CAPM is also weak in projecting value premium effects in particular markets like USA. To overcome the shortages observed by Fama and French (2006) in the CAPM theorem, Fama and French (2006) proposed “Three Factor Model”. Fama and French are of the view that their model has the tendency to accurately project the returns on common stock and the value premium effects therein. Moreover, three-factor model has also been used to suggest that changes (?) in the cross section analysis of a given stock market and its return, which CAPM theorem cannot provide. Dimson et al. (2003) used three factors model for testing the value of premium effects within the markets of United Kingdom. For this purpose, they used a newly generated set of financial information, starting from 1995 and extending to 2001 for the sake of covering all enlisted stocks on London Stock Exchange. With the empirical analysis, the researchers found that there is a strong value increment in the value of premium effects for stocks enlisted. These results were also affirmed by another research carried out by Horani et al. (2003). These researchers evaluated the relationship between the returns on stock and the research and development activities carried out by multiple organizations within UK’s market. For this purpose, Fama and French’s Three Factor Model was utilized by the researchers, which provided the results reflecting a strong bond within the variations in stock returns linked with research and development efforts of the organizations. Malin and Veeraghavan (2004) also carried out a research investigating the major European markets like Germany, England and France. The research focused on the time period from 1992 to 2001 using the three-factor model. The results reveled that the financial and functional environment of UK supports big firm effect. On the other hand, small firm effect is evident in other European countries such as Germany and France. However, the overall results stated by researchers showed that there is no significant value effect in any of the above stated three markets. The results provided by the study carried out by Bhatnagar and Ramlogan (2007) reveal that the three-factor model outclassed CAPM on both full period CAPM implementation and Split Sample CAPM implementation in the stock markets of United Kingdom. There were no pricing errors observed in the explanation provided for asset returns. Moreover, the study also identified that the results retrieved from the analysis provides that an investor who possess the possession of large stocks in organizations with large equity in the market, have the tendency to achieve superior returns on the assets deployed. List of References Al-Horani, A., Pope, P.F., Stark & W., A., 2003. R&D Activity and Expected Returns in the United Kingdom. European Finance Review, 7(1), pp.26-46. Bhatnagar, C.S. & Ramlogan, R., 2007. The CAPM Versus THM: A United Kingdom Perspective. Research Report. Trinidad: The University of the West Indies The University of the West Indies. Brealey, Richard A?., Myers, S., & Allen, F. (2011). Principles of Corporate Finance . New York: McGraw-Hill Education. Dimson, E., Nagel, S. & Quigley, G., 2003. Capturing the Value premium in the UK 1955-2001. Financial Analysts Journal, 59(1), pp.35-46. Fama, E.F. & French, K., 1992. The Cross-Section of Expected Stock Returns. Journal of Finance, 1(1), pp.427-66. Fama, E.F. & French, K.R., 1995. Size and Book to Market Factors in. Journal of Finance, 50(1), pp.131-55. Fama, E.F. & French, K.R., 2006. The Value Premium and the CAPM. Journal of Finance, 61(1), pp.2163-85. French, C.W., 2003. The Treynor Capital Asset Pricing Model. Journal of Investment Management, 1(2), pp.60-72. Kurschner, M., 2008. Limitations of the Capital Asset Pricing Model (CAPM). Norderstedt: GRIN Verlag. Levy, H., 2012. The Capital Asset Pricing Model in the 21st Century. NY: Cambridge University Press. Malin, M. & Veeraraghavan, M., 2004. On the Robustness of the Fama and French multifactor model: Evidence from France, Germany, and the United Kingdom. International Journal of Business and Economics, 3(1), pp.155-76. Mossin, J., 1966. Equilibrium in a Capital Asset Market. Econometrica, 34(4), pp.768-83. Naylor, T.H. & Tapon, F., 1982. THE CAPITAL ASSET PRICING MODEL: AN EVALUATION OF ITS POTENTIAL AS A STRATEGIC PLANNING TOOL. Management Science, 28(10), pp.1166-73. Ross, S.A., 1977. The Capital Asset Pricing Model (CAPM), Short-sale Restrictions and Related Issues. Journal of Finance, 32(177). Ross, S.A., 1978. The Current Status of the Capital Asset Pricing Model (CAPM). Journal of Finance, 33(1), pp.885-901. Rubinstein, M., 2006. A History of the Theory of Investments. NY: John Wiley. Sharpe, W.F., 1964. Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk. Journal of Finance, 19(1), pp.425-42. Read More