Principles of Finance and Capital Asset Pricing Model - Term Paper Example

CAPITAL ASSET PRICING MODEL Introduction Capital asset pricing model is a method which is used to determine cost of capital in the market. The paper will start with the definition and presentation of capital asset pricing model and show why it is not a valid method of estimation in the capital asset market. Assumptions of the model will be outlined and a clear explanation as to why the model is not good in the emerging capital asset market. The method classifies capital assets into risk free assets and risky assets in pricing approach. The concept of beta is used to measure risk asset of the asset and then it is incorporated in the formula. Since capital asset pricing model is not a valid method, there are alternative methods used instead of CAPM. Alternative method includes weighted average cost of capital plus the tailor made marker risk assessment method. The paper ill illustrate the reason as to why the weighted average cost of capital is a better method/approach than the capital asset pricing model method. A brief conclusion will summarize why capital asset is a biased methodology and present why WACC is a better method in assessing cost of capital. Body E (ri) = Rf + Bi [E(rm) – Rf ] Where E (ri) is the required rate on financial assets Rf is the risk free rate of return Bi is the financial asset beta value and E (rm) is the capital market average return Beta measures investment risk of non-diversified venture. Beta measures risk of an already diversified investment portfolio. Beta risk is the only risk which investors do receive a relatively high return than the risk free interest rate. The beta part of asset serves to measure riskiness in an asset. Beta measures individual asset risks and represents non diversifiable risk part of an asset. Beta of a portfolio is an average measure of all individual betas of an asset. Individual asset standard deviation squared measures risks associated with deviations/fluctuation of asset rate of return over time. Capitalasset pricing model is used to explain the relationship between expected return and risk and then used to price risky securities1. Risk asset=risk free asset + Beta of a security (expected market return of asset minus risk free asset) According to the CAPM, investors are compensated for taking risk and so as to capture the element of time value of money in valuation of risky assets. The risk free rate captures the time value of money in the above formula.it shows how an investor ought to be invested for putting resources in a certain investment over time. Beta is a measure of risk in the model2. The decision rule in the model is that an investment is only undertaken when the expected return meets required return in an investment3. A security market line shows the relationship between CAPM results and various risks in the capital market. Risky assets are the assets which are traded in the asset market. Risk free assets refer to the process of lending and borrowing of assets with a certain interest rate. The CAPM assumes information on variances, covariance, and expected returns on assets is fully available. The model is applicable for risk adverse investors. The investors are assumed to be rational in their investment decisions. Rationality in this case implies investor’s objective is to maximize returns from risky investments. Since investors use the same method and have full information, then all investors choose a portfolio which is a mixture of risk free asset and risky assets.in other words, investors choose a portfolio based on same information, same decision methods, and same efficient frontier. Market portfolio is the efficient fund in the model. The CAPM assumes that the market portfolio should not be calculated using Markowitz model since it is the same for all investors4.Markowitz model was the first mathematical model for portfolio diversification and optimization. The model advises on multiple investments rather than one asset. An equilibrium market (equilibrium condition in the capital asset pricing model) exists such that; Asset weight in the market=total value of shares in the market divided by market value of capital The model is of the idea that highly demanded assets in the market will attract high prices and subsequently yield high expected return rates. Repeated trading of high return assets will adjust the prices until equilibrium is reached. In order to calculate the market portfolio, we only need individual value of assets in the market. There is no need for an optimization method to calculate market portfolio. We do not need also details on variances, covariance, mean rates and even risk free rates. All risky assets assume a non-zero assets capital value in the open market. The market portfolio includes all risky assets even though some risky assets may have relatively small weights5. Reasons as To Why Capital Asset Pricing Model Is a Biased Methodology Capital asset pricing model integrates both debt and equity. The method considers only two sources of capital. The method provides biased estimates of capital assts. The capital asset model results are relatively low in relation to associated risk. There is a systematic biased estimation of cost of capital in emerging markets. Companies cannot use capital asset pricing model in industrialized countries and thus investment in emerging markets. A new method is needed to address nature of risks in new emerging countries and potential financial and economic shocks which is common in emerging countries. The capital asset pricing model uses risk-free asset interest values, levered beta of a company and equity market premium. The levered beta of a company depends on home stock market6.we need to strip the impact of debt from the company beta before we conclude on the appropriate beta to be used. Unlevered beta means the removal of impact of debt on the equity. Levered beta is used in valuation of capital structure of company. After the process of levering, levered beta is applied in the calculation of cost of equity. CAPM is based on four assumptions. The first unrealistic assumption argues that investors can borrow and lend assets at risk free rate. It is impossible for investors to borrow at the same rate as the government.it is difficult to accurately determine proxy of beta in risk measurement. Financial analysis use CAPM to estimate long term government bonds with duration of ten to twenty years. A 5-6.5% is commonly used. The common problem with CAPM is that CAPM estimates produce noisy estimates. Estimates have wide fluctuations from the correct estimates. Both debt and equity use the same weight. Short term yield on government securities is commonly used in determining risk free rate. The disadvantage of the yield is that it keeps on changing and thus introduces volatility in the market. Market returns is the sum of market dividends and capital gains. Sometimes market returns are negative. Market returns are not true representatives of future market return and thus provide biased estimates. Biased estimates are as a result of smoothening of short term returns using long term returns. The model only focuses on risk adverse investors. In the emerging markets, we have risk adverse, risk neutral and risk seeking investors. The different attitudes to risk will determine investment decision in the market. Risk seeking individuals make investment decisions when the absolute risk aversion coefficient is less than zero. When the absolute risk aversion coefficient is zero, the individual is referred to as risk neutral investor in the capital asset market. The model assumes investors have full information about the market. This is unrealistic assumption. The problem of asymmetric information of incomplete information is very common in the capital market. The problem leads to the moral hazard manifestation. It is unrealistic assume that all investors have equal access to information on valiance, covariance and expected rate of return on assets. The model also assumes that there is a positive relationship between pries of assets and expected return rates in the market7. Weighted Average Cost of Capital as a Valid Method of Cost of Capital Estimation The WACC method is a solution to inefficiencies of the capital asset pricing model. The WACC is applicable in emerging investment markets. The method introduces an element of risk premium in the calculation of cost of capital. The risk premium adjusts for macroeconomic shocks in emerging economies. The risk premium captures reality that economic shocks affect the NPV of invested funds. The risk premium adjusts the net present value of capital assets in the market. The risk premium is obtained through a quantitative analysis of economic and financial shocks in the market. There is no direct link between signals of observed prices in emerging markets. The WACC is based on application of a risk monitor in risk measurement in robust and emerging markets8. Weighted average cost of capital depends on all sources of capital it depends on bonds, common stock, preferred stock and other long term debt. There is a positive relationship between WACC, beta and return rate on equity. WACC= E/V * Re + D/V *Rd *(1-TC) where TC is the cost of tax WACC captures the advantage of tax shield in emerging markets, this helps accepting higher risk projects/ventures. The risk adjusted WACC incorporates cost of equity. To begin with, equity beta is changed into asset beta. The second step involves readjustment of asset beta to show project gearing levels. CAPM beta is used to find cost of equity. The calculated cost of equity is then used to find the WACC. The project is then evaluated by calculation of net present value. Where Re is cost of equity, Rd is debt cost, E is the equity market value, D= is the value of debt in the market and Tc is the corporate tax rate. Net Present Value= the current value of cash flows at discounted weighted average cost of capital Most of the emerging markets have their own unique risks. A good example of risk is political instability in different countries. Political instability affects investor expectations of returns after initial investment. Risk assessment in WACC aids in realistic valuation of capital assets. Risk premium is added to the discount rate before actual valuation is done. Sovereign debt spread between developed country interest rate and emerging market interest rate is use when there is correlation between company cash flows and payment on government bonds. Each source of capital in the WACC uses a different weight. Market conditions such as tax rates and interest rates influence a company’s WACC. Dividend policy, capital structure and investment policy of a firm influences WACC.The WACC increases with increase in project risks.it are only sources of funds that come from investors which are used in determination of capital components. Account payables, deferred taxes and accruals are used in calculation of WACC. This is because the sources do not come from investors. We usually adjust for account payables, deferred tax and accruals when one is determining cash flows of a project9. Flotation costs are usually ignored when calculating WACC. Flotation costs depend on type of capital raised and firm risks factors. Common equity has the highest flotation costs. Project flotation costs are small since firms do not issue equity frequently. This explains the reason for ignoring flotation cost when calculating weighted average cost of capital. Different components of capital have different risks. The structure of WACC is usually adjusted for capital structure and risks associate with the different components10. There is positive relationship between weighted average cost of capital and project risk. Conclusion Capital asset pricing model is not a valid method of estimation of cost of capital in the emerging markets. CAPM integrates debt and equity. It does not consider other sources of capital such as bonds. The method considers risk aversion as the only attitude towards risk. Attitudes towards risk include risk aversion, risk seeking and risk neutral investors. CAPM makes unrealistic assumption that firms lends or borrows at the same rate as the rate o government. The method provides biased estimates of capital assts. The capital asset model results are relatively low in relation to associated risk. There is a systematic biased estimation of cost of capital in emerging markets. Companies cannot use capital asset pricing model in industrialized countries and thus investment in emerging markets. A new method is needed to address nature of risks in new emerging countries and potential financial and economic shocks which is common in emerging countries. An alternative and better method to assess capital is the use of weighted average cost of capital. Risk premium is included to adjust for economic and financial shocks in the economy. Weighted average cost of capital depends on all sources of capital it depends on bonds, common stock, preferred stock and other long term debt. Most of the emerging markets have their own unique risks. A good example of risk is political instability in different countries. Bibliography Anderson, Patrick. 2013. The Economics of Business Valuation Towards a Value Functional Approach. Palo Alto: Stanford University Press. http://public.eblib.com/choice/publicfullrecord.aspx?p=1211882. Besley, Scott, and Eugene F. Brigham. 2011. Principles of finance. Mason, Ohio: South- Western. Brigham, Eugene F., and Michael C. Ehrhardt. 2013. Financial management: theory and practice. Mason, Ohio: South-Western. Fried, Gil, Steven J. Shapiro, and Timothy D. DeSchriver. 2008. Sport finance. Leeds: Human Kinetics. Ogilvie, J. 2009. F3: financial strategy. Oxford: CIMA/Elsevier. Ogilvie, J. 2008. Management accounting - financial strategy. Oxford: CIMA. Pratt, Shannon P., and Roger J. Grabowski. 2010. Cost of capital applications and examples. Hoboken, N.J.: John Wiley & Sons. http://www.books24x7.com/marc.asp?bookid=40625. Read More