Portfolio Diversification and the Capital Asset Pricing Model - Essay Example

XXXXXXXX Number: XXXXXXX XXXXXXX XXXXXX of XXXXXXX Corporate Finance Case Assignment 3: RiskAnd Return, Portfolio Diversification And The Capital Asset Pricing Model; The Cost Of Equity The company chosen for this SLP is Federal Express. This report aims at discussing the best model that can be used by the company. The paper will discuss the three models, i.e. CAPM, Dividend Growth and APT. The basic thought process behind the investment decisions revolves around the profit gained by owning a large or small share of a corporation or other businesses. The investment decision is really a two-pronged question: ‘What is the Potential Income?’ and ‘How risky is the venture?’ (Silbiger). High returns are not the only deciding factor for investments. It depends on the risk involved in that investment. Hence the investment decision is dependent on the returns, the risk involved (amount of uncertainty in generating the expected returns) and also the investor’s utility indifference (attitude towards risk and expected returns). A risk averse individual will always aim to reduce the risk involved in his investments and ensure a high return. The investor, in light of the level of risk tolerance, must establish specific return objectives. On the basis of these objectives, he/she can opt for a varied portfolio of investments. Diversification is a way to limit or reduce the risk. Diversification is the balancing act in which the risk-return tradeoffs are adjusted. This implies the concept of relativism and indicates that it is superior to that of absolutism (Ware). Owning a number of investments can reduce the risk involved in an investment. This is called portfolio diversification. This could be by owning shares in a number of different countries or by investing in different asset classes such as fixed interest or property (Bekiaris). Investing in a wider range of domestic stocks and cash, short, mid and long-term bonds, foreign currency-denominated bonds, equity sectors, foreign stocks and emerging market stocks can reduce the risks involved in the investment (Donald). As mentioned earlier, there are three methods that can be used to estimate the rate of return for Federal Express. These include, Dividend Growth, CAPM, and APT. The Dividend growth model is one which requires the current dividend rate, the constant growth rate of the dividend and the required rate of return. Here in this model a summing of the infinite series is done to get the value of the current price. This model also requires a few more details that need to be provided in order to compute the arithmetical calculation. These include the value of ‘g’, the current rate of return‘d’. One of the biggest drawbacks of this model is that there is a difference in the cost of capital each year and it is difficult if not impossible to assign one particular rate. Also, there is another difficulty as the company does not pay a dividend. The second model in focus here is the CAPM model. The Capital Asset pricing Model describes the relation between the expected return and the risk. This relationship is used in the pricing of the risky securities. This is generally calculated using the following formula: The methods to calculate the project beta: a) direct estimate of the project business risk that is mainly calculating the betas from the forecasted data and, b) deriving estimates from already published equity beta which mainly refers to using the historical data to calculate the betas. In both the methods CAPM is used to derive the company’s cost of capital which is then used as the discount rate for individual projects (Learning Matters). The model is relatively simple to use however this is only if the three inputs are readily available. However these can also be obtained from the following; risk free rate – government securities, beta – financial websites and expected market return – from stocks over a period of time. In the case of different betas a security market line can be plotted. The third and final method is the Arbitrage Pricing Theory Model. Here a linear equation is used to model the financial assets using the different macro economic factors or the theoretical market indices. Here the sensitivity to changes for each factor is represented by the factor specific beta coefficient. The formula is “Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n). Where: rf = The risk free interest rate is the interest rate the investor would expect to receive from a risk free investment.  b = the sensitivity of the stock to each factor and factor = the risk premium associated with each factor” (Money-Zine). This method is relatively difficult to use because it requires the company, i.e. Federal Express to find each of the factors that affect the stock and also the expected returns for each of the factors. The risk free rate is assumed to be the return from the US Treasury Bonds, as they have a very negligible risk attached to them. Currently, the return on three month US Treasury Bonds (10 year notes) is 3.7 % (Zeng, 2009). Hence the Risk free rate is 3.7 %. The market risk premium is taken as the return on the S & P 500 Index, as it the most widely accepted stock market index. The 15 – year annualized return on the S & P 500 Index is about 6.19 % (Jim, 2008). Similarly the beta value of the company can also be found easily in various websites like Yahoo finance. Comparing the three models it is clear that CAPM is the best option that can be used for the company. This is simply because the method is very accurate and simpler to calculate when compared to the other two methods. Also in terms of accuracy the CAPM model takes into account three main figures, i.e. the risk free rate, the beta and expected market return. These are easily available and can be used to find accurate answers. In other words, the capital asset pricing model is easy to use as well as reasonably accurate. Considering the dividend growth model, it is seen that the earnings growth is the same for perpetuity. However for Federal Express, the company can consider a high growth rate over a long period of time. Also the stock returns to the investors is dependent directly on several independent factors, hence it is difficult to use the arbitrage pricing theory for the company. Conclusions: In conclusion based on a study of the three methods, it is safe to say that the Capital asset pricing model theory is the best and safest method that can be used for Federal Express. This is because the method is simple to apply and it only considers the risk of a particular stock relative to the rest of the stock market. The beta value for Federal Express is found to be 1.14 (Google Finance).The CAPM can be used and the government bond rate as discussed earlier can be taken as the risk free rate. Also from the movement of the stock index the expected market return can also be found easily. The CAPM also makes a few assumptions that include a perfectly competitive market, trade without transaction or taxation costs and also information is at the same time and is available to all investors. These assumptions are realistic and hence make the results of the Capital assets pricing model more effective and efficient. Hence CAPM must be chosen. Works Cited Bekiaris, M. "How risky are shares?" Money (2003): p67. Donald, C. "The beauty of diversity." Maclean’s Vol. 114, Issue 36 (2001): 42. Google Finance. FedEx Corporation. 2010. 15 February 2010 . Matters, Learning. Caluculating Risk – Adjusted rate of return. 2010. 14 February 2010 . Money-Zine. Arbitrage Pricing Theory or APT. 2007. 14 February 2010 . Silbiger, S. The 10-Day MBA. Mumbai: Magna Publishers, 1999. Ware, W. J. "Quantum Investing." Financial Analysts Journal, Mar/Apr 1992, Vol. 48, Issue 2 (1992): p10-22. Read More