Capital Asset Pricing Model - Coursework Example

Capital Asset Pricing Model (CAPM) Theories and practices in corporate finance have been changing since the early 1950s. From the previous normative approach to the now positive approach, these theories and practices have been used to examine the causes and reasons of investor reactions to corporate decisions in relation to their financial and investment decisions (Torrez, et al., 2006, p.39). The many techniques applied to determine the value of an organization have always remained a crucial concern in corporate finance (Torrez, et. al., 2006, p.39). Bradley (2012) has pointed out that the study of how a company gains access to capital markets is known as corporate finance. The principles of corporate finance are being applied to the various financial products existing in todays organizations. In a practical sense, corporate, financial policy has molded many forces, and a bit of those are irrelevant or if not unconcerned with shareholders worth (Avellaneda, 2001, p.37) A firms value has been described "as the sum of the discounted values of the free cash flows released by an asset," wherein the rate of discount is gained out of computing the sum of risk free rate and the "product of the assets beta and the market premium" (Magni, n.d., p.2). Still, the said consideration, according to Magni (n.d., p2), is to some extent ambiguous and is in contrast with what some finance scholars believe. Apparently, there are some comparisons with how some corporate finance scholars make use of the term beta. According to these finance scholars, equilibrium beta must be used that is based on an assets equilibrium value (Bogue & Roll, 1974; De Reyck, 2005; Ekern, 2006 cited in Magni, n.d., p.2). On the other hand, other finance scholars make use of disequilibrium beta, which relies on asset cost (Rubinstein, 1973; Lewellen, 1977; Jones and Dudley, 1978; Copeland and Weston, 1988; Bossaerts and Ødegaard, 2001 cited in Magni, n.d., p.2). The Capital Asset Pricing Model (CAPM) is one comprehensive concept in corporate finance literature. It has been widely utilized as a tool for the valuation of firms as well as in making capital budgeting decisions (Rubinstein, 1973; Rao, 1992; Damodaran, 1999; Brealey & Myers, 2000; Fernández, 2002 cited in Magni, n.d., p.2). The presence of Capital Asset Pricing Model (CAPM) has placed the present value formula into a risky position. That is because the CAPM gives value to the risks of on asset at the same time making use of the present value formula (Bradley, 2012). The Capital Asset Pricing Model equation E[Ri] = Rf + Bi (E (RM) -Rf) Here is a sample calculation using the CAPM: When the risk free rate is 7%, expected return on market portfolio is 13%, and beta of the stocks is 3, the expected return on a stock is being solved as follows: E[Ri]= Rf + Bi (E (RM) -Rf) E[Ri]=7% + (13% - 7%)3 = 25 % E[Ri]=25% Upon its introduction to the corporate scene, practitioners have well embraced the use of CAPM. When CAPM was conceptualized, researchers and practitioners felt glad because by making use of the model they can make predictions with the risk return characteristics of assets (Graham, et al., 2010, p.208). Bruner et al. and Graham and Harvey (cited in Dayaratne, et al., 2006) also consider CAPM as one effective method used by practitioners in making estimations of expected returns, financial decisions, capital decisions, and in a companys performance evaluation. Aside from practitioners, academics usually apply CAPM in making estimates of expected returns (Dayaratne, et al., 2006). As a matter of fact, according to the PWC survey of South African investment professionals, CAPM is seen as the most dominant method applied by organizations in computing for their cost of equity (Correia, 2010, p.430). For instance, financial managers employ this method when making crucial decisions that deal with risks and its reduction (Correia, 2010, p. 430). CAPM is not only a tool for investors in making decisions "with a portfolio financial asset,” but in a more practical sense, it is a strategic planning tool for an organization that handles a portfolio of several business units, divisions, and branches (Naylor & Tapon, 1982, p.1167). Indeed, CAPM is one practical tool for corporations in making relevant decisions since it enables them to make earlier forecasts of expected returns. CAPM presupposes "a linear relationship between the expected rate of return and systematic risk of a security or portfolio” (Torrez, et al., 2006, p.44). The development of CAPM is being attributed to the following researchers, Sharpe (1964), Linter (1965), and Black (1972), where the term SLB model originated (Torrez, et al., 2006, p.44). Usual CAPM computations make use of actual returns to obtain an approximation of the beta coefficient. Approximations are often realized by going back to securities excess return (Ri-Rf) through the market excess return (Rm-Rf.). As claimed by Farma and French (cited in Torrez, et al., 2006, p.45), the capacity of CAPM to anticipate returns of a firm is insignificant. However, in contrast to that statement, Coates et al. (1995) and Green et al. (1996) (cited in Torrez, et al., 2006, p.45) have both acceded to the notion that beta is still used extensively to measure risk. Fundamentally, beta is still utilized to approximate excess return (ER) and cost of capital. Furthermore, anticipation of cost of capital through CAPM is deemed more sensible in comparison with Dividend Growth Model (DGM) (Torrez, et al., 2006, p.45). Despite the attention given to the use of CAPM in companies, this principle of corporate finance also has its downsides and boundaries, which have to be acknowledged to understand the theoretical model. Assigning values for CAPM variables is a difficult first step into solving the CAPM equation. First and foremost, before one can make use of the CAPM model, the Rf, Rm, and the equity beta must be given a corresponding value. "The yield of the short-term government debt," which is utilized as an alternative to Rf, is unsteady, and it tends to change every single day based on certain economic circumstances (Head, 2008, p.52). Hence, estimating the Rf is already a hard thing to do, and unless the short term average value is used, this inconstancy will remain. Another disadvantage of using the CAPM model is the complexity in assigning the value of the Rm (Head, 2008, p.52). Stock returns are sums of "average capital gains and average dividend yield" (Head, 2008, p.52). Values of beta are seen as unfixed, making it hard to assign its values for CAPM computation (Head, 2008, p.52). Another serious weakness of CAPM is rooted from its declared objectivity. Finance literature of the recent times has given a perception that there exists a method that will accurately estimate the cost of equity capital; a thing that the CAPM is able to provide (Pereiro, 2002, p.102). However, several scholars have questioned the impartiality of the CAPM rate, contending that discount rates are merely subjective parameters (Pereiro, 2002, p.102). These researchers have expressed their belief that the CAPM is an ineffective method to discover new ventures because the analytical allocation of returns is earlier unknown (Pereiro, 2002, p.102). The contention of other research scholars that CAPM is irrelevant is also one shortcoming of the concept. Irrelevance here is referring to its conceptual validity or simply the definition of risk that it usually imparts. The definition points to the covariance that exists between market returns and the company (Pereiro, 2002, p.102). Pereiro (2002, p.103) has further argued that CAPM’s failure in capturing unsystematic risk is also an evident flaw of this approach. The CAPM only emphasizes that "only systematic risks pays" because when the size of a financial portfolio increases, diversity begins, and unsystematic risk will disappear. On the contrary, for instance in the U.S. market, systematic risk is thought to explain returns, but then it has been proven that unsystematic variables such as the market cap, book value of equity, as well as the price earning ratio (PER) impel stock returns (Pereiro, 2002, p.103). This is the reason why some analysts argue regarding the inaccuracy of the classical CAPM in explaining the value of stock returns. Handling real assets do not simply take into account buyers or sellers who trade stocks, but it also involves entrepreneurs who get to be affected by uneven information when they buy or sell content-tangible assets (cash, equipments, buildings, content-intangible assets (patents, trademarks), or process-intangible assets (knowledge in obtaining more useful benefits than competitors in utilizing those aforesaid resources) (Pereiro, 2002, p.103). The impact of diversification on real assets has stimulated debates. Nonetheless, corporate diversification permits a reduction in cost by means of taking advantage of the economies of scale, in particular, when dealing with related diversification (Pereiro, 2002, p.103). According to Mullins (1982), the application of CAPM in corporate finance poses several shortcomings. He stressed that the model do not provide an exact description of the financial markets behavior. Secondly, he stated that the extensions of CAPM were only created by researchers, to enhance its realism. Basically, practical and theoretical problems are being linked with the application of CAPM, and so, this continuous to be another area of focus for further study. On one hand, Mullins (1982) believes that CAPM and its extensions are still employed by investment managers. It is a significant development in corporate finance that has somehow helped corporations obtain assumptions of their cost of equity. However, due to its weaknesses, financial executives cannot depend on CAPM as one accurate means to estimate the cost of their equity capital (Mullins, 1982). Despite its shortcomings, CAPM may still provide information regarding the movement of returns in financial markets, and that its flaws are deemed more uncomplicated compared to other approaches. It is an approach that aids in making sound financial decision, if fused with the traditional techniques and proper judgment (Mullins, 1982). The approaches that are applied to aid in making decisions for corporations all have their downsides. Therefore, no other means can provide an exactly accurate estimate amount of returns, cost equity, or assets, not even the CAPM. The CAPM is not exempted from the fact that it may have flaws, which may somehow affect the results generated when making use of its formula or equation. However, in spite of the many criticisms thrown to this approach, CAPM will remain useful especially if applied in the making of financial decisions for corporations. Still, in the application of CAPM, it is essential to be mindful of the reality that it must not become the sole basis in making financial decisions because there may be other approaches present that can help a firm make those relevant decisions. Word count: 1767 References Avellaneda, M., 2001. Quantitative analysis in financial markets: collected papers of the New York University mathematical finance seminar, volume 3. Singapore: World Scientific Publishing Co. Pty. Ltd. Bradley, J.B., 2012. Principles of corporate finance. [Online] (Updated 2012) Available at: http://www.ehow.com/about_5068142_principles-corporate-finance-solutions.html [Accessed 7 February 2012]. Correia, C. Flynn, D. Illiana, E. & Wormald, M., 2010. Financial management. Cape Town: Juta & Co. Dayaratne, D.A.I. Dharmaratne, D.G. & Haris S.A., 2006. Measuring the risk and performance in plantation sector using capm based Jensens alpha. Sabaragamuwa University Journal, 6 (1), pp. 68-81. Graham, J. Smart, S.B. & Megginson, W., 2010. Coporate finance: linking theory to what companies do. Mason, OH: Cengage Learning. Head T., 2008. CAPM: theory, advantages, and disadvantages. Student Accountant, June/July, pp.50-52. Magni, C.A., n.d. Firm value and the mis-use of CAPM for valuation and decision making. [Online] Available at: http://berkeleymath.com/Documents/misuse_CAPM.pdf [Accessed 7 February 2012]. Mullins, D.W., 1982. Does the capital asset pricing model work? Harvard Business Review, 1 Jan, pp.105-114. 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. 1163-1173. Pereiro, L.E., 2002. Valuation of companies in emerging markets: a practical approach. New York: John Wiley & Sons, Inc. Torrez, J. Al-Jafari, M. & Jumah A., 2006. Corporate valuation: a literature review. Inter Metro Business Journal, 2 (2), pp.39-53. Read More