Aspects of Making Rational Investment Decisions - Essay Example

Introduction Assessing the correct required rate of returns is one of the most important aspects of making rational investment decisions. Since required rate of return serves as the basis for making economic decisions to invest or not to invest, it is therefore important that its assessment and calculation must be done more accurately. Capital Asset pricing model is one such tool which is used to calculate the rate of return on any given security by considering the risk and return profile of the individual security. What is also important to understand that Capital Asset Pricing Model or CAPM relates the returns on one individual security with that of the market and as such it considers the risk of the market as well as the risk of the individual security. So called beta is therefore the exact measure which shows the relationship between the risk and return of the individual security with that of the market by calculating the co-variance of returns on individual security with that of the market. CAPM also assumes that the investors are well diversified and they only attempt to reduce the systematic risk that is arising out of the market. As such beta is the measure which calculates this systematic risk and is always assumed to be 1 for the market as a whole. The basic purpose of this paper therefore is to respond to certain tasks as outlined and perform some calculations and discussion on the types of growth path to be adapted by the firm. 1) Description Co-variance Variance Beta – 1 Beta-2 XSTRATA 380454.4 - 0.73 1.99 FTSE 100 - 380454.4 1 1 ENRCL ` - 0.45 1.23 *for detail calculations see appendix1 The above calculations indicate that the beta calculated through two methods is different from each other. Beta-1 is calculated through the traditional method of finding the covariance and variance and then taking the ratio of two whereas beta 2 is calculated through regression analysis by taking the slope of the % change in the returns of the market and the individual security. The differences in the value of the two betas may be attributed to the relative differences in the two methodologies. 2) Name of Company Beta Calculated Beta Published XSTRATA 0.73 & 1.99 2.482 ENRCL 0.45 & 1.23 2.143 The published betas of two companies are 2.48 & 2.14 and are significantly different from calculated beta. (digitallook.com,2010. The above calculations indicate differences between the beta calculated and beta that has been published in various external sources. The changes or differences in the value of two betas may be attributed to different betas. The beta which has been calculated is based upon the closing price of the stock whereas published beta may have taken the adjusted prices of the shares while accommodating any dividends or splits. Thus the overall beta may be different from published sources if there exists a difference in calculations. The differences in the beta can also be attributed to the geared and un-geared beta based on the method of calculation. Un-geared beta or asset beta takes into consideration business risk only whereas the geared beta or equity beta takes into consideration the business as well as finance risk. As such the differences between the published beta and the calculated beta can be a direct result of the overall approach adapted while calculating it. Further, the overall time frame taken to calculate the beta can be different too. In this case, beta has been calculated by taking two years monthly data whereas published beta may have been calculated by taking a short or longer time horizon thus giving the overall differences between the two values. It is also possible that the published sources of beta may have taken a different market index to calculate the beta as compared to the beta calculated using FTSE 100 in this case. 3 Similarities and differences between beta of different companies Beta essentially measures the relationship between the risk and return profile of the market as well as the individual security. A positive beta indicate that the firm and market moves in the same direction i.e. an increase in index also means that the stock will increase too whereas a decrease in index also result into decline in the returns of the stock. A negative beta however, shows a negative relationship between stock returns and market returns as market and stock moves in opposite direction. The differences between the betas of different companies can be the result of different dynamics that each individual company faces. Companies in same industry or sector may be having closely resembling betas whereas the companies in different sectors may have entirely different betas depending upon the nature of the industry. Further, beta is a measure of risk therefore if the risk profile of two companies is relatively same with respect to the market; it is mostly likely that the beta values will also be close to each other. For example, in case of XSTRATA and ENRC, both the companies are working in the same industry with close betas however; the differences can still be attributed to the behavior of individual security with respect to the market returns. It is also critical to note that the market returns are mostly based on the different factors and as such the essential differences between the fundamentals of the two companies in terms of their financial health and confidence of the investors in the future viability of the firms. The price to earnings ratio of XSTRATA is 70.744 whereas its EPS is 12.63 xs against the P/E of 16.3 & EPS of 81 for ENRC5. (ft.com, 2010). These two estimates therefore provide a clear indication of the overall confidence of the investors into XSTRATA because its P/E ratio is 70.74 which are significantly higher. It may be because of this reason that the beta of the two companies is different from each other. Further, the time span of the data is one critical factor which can also produce the differences in the values of the two betas. It is however, assumed that the time period of both the published betas is same. 4 (a) Capital Asset Pricing Model is one of the well known methods for calculating cost of capital for any given project or proposed investment. It was one of the earliest attempts to calculate the required rate of return on any investment by linking the risk as well as return together. There are different types of risk premiums which are integrated into the capital asset pricing mode i.e. risk free investment, market risk as well as the individual risk of the security. What is also important to note that the CAPM also related the risk and returns of the individual security with that of the market therefore integrating risk as one of the most important components of calculating required rate of return? Considering the statement of Hamilton, it is important that one must undertake to explore as to how risk is considered in the process of assessing the cost of capital with the help of capital asset pricing model. The basic formula of CAPM is : Re = RF + b(KM-RF) Where RF= Risk Free Rate, KM- RF = Market risk Premium and b= beta The above formula therefore integrates the risks into the calculation of required rate of return. The question of why the CAPM allows risk to be taken into consideration at the time of making capital investments is therefore important question to ask. While making any investment or capital expenditure decision, future cash inflows of the project or proposed investment are divided by the appropriate cost of capital. Cost of capital is however, is also a measure of the risk as the investors, in order to compensate themselves against the various risks tend to charge risk premiums. Such risk premiums however, are accounted for through the required rate of return which includes the various risks that investors or shareholders are willing to take. In case of organic growth wherein a company may be interested in increasing its share of the market by acquiring a company which practically operates outside its own industry, CAPM may provide a very accurate description of how the risk in investing into a new industry can be accounted for by adjusting the required rate of returns accordingly.6 Acquiring a company in new industry will be a conglomerate diversification and as such firm must account for the risks that may be incurred as a result of perusing such strategy by the firm. One of the most important challenges faced when a firm pursues an organic growth strategy is to de-compose the growth into various elements such as revenue growth.(King, Ghobadian & O’Reagon, 2009). As such for external organic growth, it is really important that the decomposition of growth elements is properly done before assessing the relative risk associated with each element of growth. Further, in organic growth, the capital is mostly unencumbered therefore it is unconstrained with relatively low risk associated with it. In such scenario, the market risk premium will be low and capital asset pricing model will predict a relatively low required rate of return on the proposed investment b) In case of mergers and acquisitions, the overall risk is higher because two unrelated companies attempt to combine together. Though the apparent benefits of following this strategy for growth is good however, given the historical failure of the firms which merge, the risk of such transaction is always high. The basic difference of pursuing an organic growth strategy and the merger or takeover strategy is the fact that organic growth does not provide an opportunity to make a quick gain whereas benefits of the merger and takeover strategy can provide quick results. Accordingly, the risk in merger and acquisition strategy is always higher as compared to the organic growth strategy thus the use of CAPM will provide moderate rate of returns in case of organic growth and higher rate of returns in other cases. It is argued that the basic rationale behind the merger and acquisition effort is to increase the overall value of the business. The in order to spot a good target company, it is important that the firm must have the ability to spot the value gap between the two companies. Spotting and exploiting value gap is critical because it allow the firm to grow and take advantage of the difference. This value is also increased by adding the value of the acquiring firm and the resulting reduction/increase into the expenses and income of the firm after the merger. As such mergers often provide a very lucrative opportunity to gain benefits on long term basis as well as to achieve other benefits such as synergy in operations etc. thus mergers and acquisitions are relatively more important and critical as compared to the strategy of pursuing organic growth however, in perusing such strategy, investors often require higher rate of return. More specific reasons for mergers however may include achieving synergy, economies of scales, higher market power as well as diversification. In such situation, the organic growth may not allow a firm to growth at the speed with which the firms can actually growth through its acquisition as well as takeover strategy. Further, it is also important that the performance measurement is better in mergers and acquisitions as compared to organic growth therefore it is always advisable that those firms which tend to grow faster must take higher risk and involve themselves into acquisition strategy rather than following an organic strategy. Finally, as discussed above that in following a merger strategy, required rate of return will be higher whereas following an organic growth strategy will require lower required rate of returns. This is mostly due to the overall risk and return relationship of each of the strategy and CAPM shall therefore capture each risk according to the methodology adapted by the firm. References 1. Kling, G, Ghobadian, A (2009). Organic growth and shareholder value: A case study of the insurance industry . International Journal of Research in Marketing. 2, pp.276-283. 2. XSTATA Share Prices [online]. (2010) [Accessed 21st May 2010]. Available from: 3. Markets Data [online]. (2010) [Accessed 22nd May 2010]. Available from: . 4. Historical Prices-XSTRATA [online]. (2010) [Accessed 20 May 2010]. Available from: . 5. Historical Price- ENRC [online]. (2010) [Accessed 20 May 2010]. Available from: . 6. FTSE-100 [online]. (2010) [Accessed 20 May 2010]. Available from: . 7. Eurasian Natural Resources [online]. (2010) [Accessed 22nd May 2010]. Available from: . Read More