Synthesis of the Asset Pricing Models - Essay Example

Corporate Finance LO1: Synthesis of the Asset Pricing Models In order to evaluate the cost of equity of a business, asset pricing models are used by the analysts. Asset pricing models also help the investors to measure the performance of the investment portfolios (Shefrin, 2005). The different asset pricing models have been discussed as follows: Capital asset pricing models: Return of a stock can be represented as a function of risk. According to Acharya and Pedersen (2005), by taking more risk, an investor can ensure better return. Therefore, the finance professionals are more inclined to determine return from an investment. Capital Asset Pricing Model (CAPM) is the most popular model used for estimating the require return based on the specific risk associated with the asset. In order to calculate the risk, CAPM considers a risk multiplier or beta coefficient (MacKinlay, 2005). However, the model is based on some assumptions: A) All the investors are the wealth maximisers and choose the investments based on the expected rate of return and standard deviation. B) There is no limitation on lending or borrowing of the investors. In addition, the investors can borrow the funds without any risk. C) No restriction will be given on short selling (selling an asset that is not yet owned by the investors). D) The expectation of all the investors related to the market remains same. E) The transaction cost is negligible. F) The cost of tax can be ignored. G) The activity of the investors does not influence the market. H) The investors can buy and sell any number of stocks. The buying and selling process can be conducted in any period of time. I) The total quantities of the financial asset remain same. However, Balvers and Huang (2009) argued that most of the assumptions of CAPM do not exist in the real market scenario. In the CAPM model, the risk measurement coefficient is considered as β. The risk coefficient is derived based on the market risk and it deviates based on the company. Formulation of CAPM: In the CAPM model, the required rate of return is calculated by the following formula: Re = Rf + β*(Rm- Rf) Where, Re= Expected rate of return. Rf= Risk free rate. β = Co-efficient of risk. Rm= Average market return. The risk free rate of return depends on the economic condition of the market and the particular industry (Blitz, 2014). For example, due to the inflation of the market, the purchasing power of the investors may decrease. In this regards, Brennan, Wang and Xia (2004) argued that the risk free return is not practically feasible. The Arbitrage Pricing Theory: The alternative to the CAPM has been proposed by Ross in 1976. CAPM fails to deliver the desired outcome due to its impractical assumptions. For example, it has been assumed that all the investors share the same kind of information and possess same amount of information. It may not be feasible in the real market scenario. Moreover, Fama and French (2006) argued that identifying and estimating the market return (Rm) is quite a difficult task. Thus, a different form of pricing model has been proposed named as Arbitrage pricing Theory (APT). In APT, the pricing of the equity has been derived based on the number of systematic factors. The model exposes that a set of common factors stimulate the outcomes of the market. Moreover, this model also highlights on the fact that stocks of the same industry tend to move together. The presence of the multiple factors has complicated the CAPM and also narrows down its scope. In APT approach, the values of the assets are evaluated based on the law of one price and no arbitrage. The model can be considered as a multi-factor model. APT is derived from a statistical model. However, CAPM can be treated as an equilibrium asset pricing model (Fama and French, 2004). The assumptions like equal expectation of the investors are not considered in APT. According to Grammig and Schrimpf (2009), APT model is more reasonable compared to the CAPM, as the former considers lesser amount of assumptions. The assumptions of the APT model are as follows: A) The securities have finite number of expected values and variances. B) A well diversified portfolio can be formed by some agents. C) The cost of tax and transaction are also neglected in APT like CAPM. The basic concept of APT is that an investor can value some assets in respect of the prices of the other assets. CAPM considers the equilibrium of market. However, APT reveals that in the market only one intelligent investor exists. Thus, the scope of arbitrage persists in the market. However, both in the CAPM and APT, same formula is used to evaluate the return. Though, in APT the risk factors have been calculated based on the company. Thus, an investor is required to calculate multiple betas for each of the factors. Consumption Capital Asset Pricing Model (CCAPM): This model extends the concepts of CAPM by evaluating the ability of the firm to determine the future consumption rate. CCAPM uses the consumption measures with the help of consumption beat. However, the basic formula and assumption of this model are similar to CAPM. In this context, Guermat (2014) mentioned that CCAPM only deviates from CAPM by the calculation of beta co-efficient. The beta for consumption has been calculated by estimating the covariance between the ability of the investors to consume goods and services from the investments and the return from a market index. However, CCAPM is less frequently used in the practical scenario (Magni, 2009). LO2: Critical evaluation of the company’s financial strategy: In order to improve the financial performance of the companies, the managers need to focus on the inventory management and working capital management. Strategies to manage inventory: Selecting a proper inventory management platform: The companies can select inventory management software to increase the efficiency of the financial system. The software enables the firm to synchronise the supply with the existing marketing demand. In this regards, Hirshleifer (2001) cited that the ability to forecast the market demand is the best option to manage inventory. Preparing individual supply and demand plan: One of the major reasons for mismanagement of the inventory is the complexity of the supply chain management system. Thus, the companies can be benefited by preparing separate supply and demand plan for the products. Kan and Robotti (2008) added that a proper market survey can help the managers to understand the demand of the market. The result of market research may ensure that the production units control the supply. Thus, the level of inventory can also be managed effectively. Economic order quantity (EOQ): EOQ is one of the most accepted models used for managing inventory. The model guides the inventory managers to determine the right quantity of order based on the factors such as cost of ordering, purchasing cost and annual sales volume. EOQ can be determined by the following formula: EOQ= {(2*A*Q)/(P*C)}^0.5. Where, A= Annual sales. O= Cost per order. P= Purchase price per unit. C= carrying cost. Just-in-time: Just-in-time approach does not reduce the inventory, eliminates it completely. LiHer, Masmoudi and Suret (2004) cited that a firm acquires the raw materials or manufacturing products only when it is required by the consumers. Just-in-time approach is a difficult one to be implemented in the real business scenario. However, it can bring the most effective result to manage the level of inventory. Strategies to manage working capital: The difference between the company’s current assets and current liability is known as working capital. As mentioned by Levy (2010), current liabilities of the companies arise due to the current assets. Thus, by controlling the current assets, the company can manage the working capital. Most of the companies prefer to derive the optimum level of the working capital due to the fact that both the higher and lower level of working capital can impact the performance of the company. Excess amount of working capital includes the carrying cost and lesser amount of working capital hampers the normal operation of the business. The companies implement the following strategies to manage working capital: Cash budgeting: Cash budgeting can be considered as an important strategy that focuses favourable level of cash in the business. As stated by Lewellen, Nagel and Shanken (2010), cash budgeting monitors the estimation of cash by estimating the fore coming earnings and payments. In order to effectively manage the cash in the organisation, the finance managers are needed to keep a balance between the excess and shortage of cash. However, the companies can reduce the requirements of cash by speeding up the collection process and getting relaxed credit policy. Strategies to manage the cost of capital: Acquiring the funds for the business can be considered as one of the most vital tasks for the finance managers. Li, Ng and Swaminathan (2013) mentioned that selecting the proper proportion of equity and debt is vital for the business. In addition, the companies also need to prepare the strategies for procuring funds based on the cost of acquiring the finance, amount of funds available and risk factors to acquire the funds and repayment period. However, the strategy to acquire funds also varies according to the current financial position of the company. Reference List: Acharya, V. and Pedersen, L., 2005. Asset pricing with liquidity risk. Journal of Financial Economics 77, pp. 375-410. Balvers, R.J., and Huang, D., 2009. Evaluation of linear asset pricing models by implied portfolio performance. Journal of Banking & Finance, 33 (9), pp. 1586-1596. Blitz, D., 2014. Agency-based asset pricing and the beta anomaly. European Financial Management, 20(4), pp. 770-801. Brennan, M., Wang, A. and Xia, Y., 2004. Estimation and test of a simple model of intertemporal asset pricing. Journal of Finance, 59, pp. 1743-1775. Fama, E.F. and French, K.R., 2004. The capital asset pricing model: Theory and evidence, Journal of Economic Perspectives, 18(3), pp. 25-46 Fama, E.F. and French, K.R., 2006. 6 Multifactor explanations of asset pricing anomalies, Journal of Finance, 51(1), pp. 55-84 Grammig, J. and Schrimpf, A., 2009. Asset pricing with a level of consumption: new evidence from the cross-section of stock returns, Review of Financial Economics, 18(3), pp. 113-123 Guermat, C., 2014. Yes, the CAPM is testable, Journal of Banking & Finance, 46, pp. 31-42 Hirshleifer, D., 2001. Investor psychology and asset pricing, Journal of Finance, 56(4), pp. 1533-1597 Kan, R., and Robotti, C., 2008. Specification tests of asset pricing models using excess returns, Journal of Empirical Finance, 15 (5), pp. 816-838 Levy, H., 2010. The CAPM is alive and well: A review and synthesis, European Financial Management, 16(1), pp. 43-71 Lewellen, J., Nagel, S., and Shanken, J., 2010. A sceptical appraisal of asset pricing tests, Journal of Financial Economics, 96, pp. 175-194 Li, Y., Ng, D.T., and Swaminathan, B., 2013. Predicting market returns using aggregate implied cost of capital, Journal of Financial Economics, 10, pp. 419-436 LiHer, J., Masmoudi, T., and Suret, J., 2004. Evidence to Support the Four-factor Pricing Model from the Canadian Stock Market, Journal of International Financial Markets, Institutions and Money, 14(4), pp. 313-328. MacKinlay, A.C., 2005. Multifactor models do not explain deviations from the CAPM. Journal of Financial Economics, 38, pp. 3-28. Magni, C.A., 2009. Correct or incorrect application of CAPM? Correct or incorrect decisions with CAPM? European Journal of Operational Research, 192, pp.549-560 Shefrin, H., 2005. A Behavioural Approach to Asset Pricing, Amsterdam: Elsevier Academic Press. Read More