Overview of Capital Asset Pricing Model (CAPM)
Theory
Cost of equity capital is the most complicated component of firm’s cost of capital. It is definition as the rate of return required on a firm’s shares by the investors in the financial markets is also the source of the problem because there is no direct method to discover the require return of investors ( 1999). In effect, there are two main methods like the constant dividend growth and CAPM that are used to estimate it. The use of the former leads to simplicity and ease of application of deriving the cost of equity which makes it a practical method to consider. But disadvantages arise in its assumptions. One is that the assumption of constant dividend growth which not all companies is doing. Second is deriving the value of a firm by its dividend payments which undermine other indications of growth and stability like investments that caused retained earnings to raise. In addition, data that is used to install growth rate is based on past information which is not appropriate in estimating the future returns.
With these disadvantages comes the capital asset pricing model (CAPM). The systematic risk which comprised of business and financial risks is represented by beta coefficient which is one of the key variables the CAPM ( 1999). In determining beta, business and financial risks of a company should be studied in order to give a reliable estimate of beta. Beta is important in the formula of CAPM because it serves as the multiplier for risk premium attached to a certain class of security. It will determine how an individual security or portfolio return is sensitive on overall market return. CAPM advantages are derived from its ability to include analysis on both dividends and capital gains which are undermined by constant dividend model. In effect, although more complicated, CAPM is a more accurate measure of cost of equity capital. CAPM heavily relies on scanning business and financial risks to estimate beta coefficient which able to recognize risks unlike constant dividend model.
Through Capital Asset pricing Model (CAPM), the portfolio risks are decomposed into systematic and specific risk. The former are the risks in the market portfolio which reflects how sensitive individual assets can perform as a result of being affected by market movements. It is to note that the beta coefficient of the market is equal to 1 because it is the basis. On the other hand, the latter is not included because it is already taken into account through the creation of portfolio and in both efficiency frontiers and capital market line. Overall, the conclusion of CAPM is that the assets expected returns depends on the beta (systematic risks) and not on its volatility (total risks). Ultimately, CAPM is the one that predicts the equilibrium price of an asset, however, it is only a theoretical perspective and has less to say about the level of risk an investor should put in every decision-making.
As it is said that CAPM is merely an economic theory, risk reduction is able to be achieved through the use of portfolio manipulation. But the greater chance to really pinpoint it is in the hands of the individual investors, that is, their level of risk and uncertainty regarding their investments. It is therefore concluded that objective analysis of risk reduction strategies can offer results that can minimize the risk of investors. In the contrary, when subjective analysis is involved, such risk reduction strategies will ultimately be despised because it focuses on investor tolerance or perhaps its personal investment decision.
Evidence
Supposed that Esprit condition assumed in the preceding examples do not hold. The global firm will be viewed by investors as a good investment destination but there is the need to determine the expected rate of return from the cost of capital. Using CAPM, the following Esprit information can be calculated: risk-free rate of 3%, beta (risk measure) of the stock is 2 and the expected market return over the period is 10%. The stock is expected to return 17%. This can be then used by investors in assessing the profitability of Esprit investment and in turn used by Esprit to entice capital into its coffers ( 1999).
Using the formula E(ri) = Rf + Bi (ERm – Rf) (wherein E(ri) is the required return, Rf is the risk-free rate of return, Bi is the beta coefficient and Bi (ERm – Rf) as the risk premium) we can have broader look in intrinsic value of Esprit shares. The 1-year Hong Kong Government Bond or the risk-free rate of return has 6.11% annual yield, the beta coefficient for the 2006 for Esprit is 22.68 and the market risk premium is 6%. With this we can fill the formula by E(ri) = 6.11% + 6% = 12.11%. However, CAPM merely represents the expected return fro an asset/ share while investor’s required return is the ultimate measure of investment decisions. In effect, the 12.11% can be compared to the investor’s required rate of return.
Considerations
Time value of money (TVM) is an investment principle in which investors prefers to receive the money as early as possible and that the value attached to present money holdings is greater than future or expected money holdings even they have the same nominal values ( 1999; 2006). TVM is the foundation of discounting cash flows (DCF) although applied in most big business that plans to undergo huge financing for a project or several projects. DCF methods relies on discounting tables wherein a specific year of cash inflow/ outflow as well a specific cost of capital (e.g. CAPM) are used to determine the rate in which net income or net loss will be discounted in present values (e.g. the discount rate). Without acceptable criteria that intend to measure these variables, the determined rate will not be objective weakening coherence of DCF derivation. Therefore, CAPM as a measure of cost of capital should be able to reflect the costs associated with certain investments (e.g. bonds, stocks, etc.) to maintain the integrity of DCF analysis.
As standard deviation is used to measure an asset’s total risk, beta coefficient measures the market risk of a certain asset (e.g. shares) which cannot be reduced through diversification ( 1999 . ). Beta represents systematic risks that cannot be diversified because the risks in individual assets within a portfolio are correlated with other assets ( 2007). When a company has high beta, it is ideal to use equity financing. Investors require a rate of return higher than the market average and a beta of 1.5 is simply an indication that company’s shares provide returns 50% higher on every dollar return in the market average.
Individual betas are equal to the covariance between the share returns and the market returns divided by the variance of the market returns. For the portfolio beta, the same procedure as getting the expected return and standard deviation of portfolios in which the weighted average of betas of individual securities are calculated. The risk premium is represented by “beta multiplied by the difference of market return and risk free rate”. This is the compensation a risk-taking investor is compensated for. As securities should be competitive and it will not provide returns below risk free rate of return, CAPM can derive the required rate of return on an asset/ share of investors because it represents the sum of risk-free rate (i.e. the risk-averse option) and risk premium (i.e. the risk-taking compensation).
CAPM can be graphed and expressed in a straight line equation such as y = ax + c which is referred as security market line (SML). In SML equation, expected market return (y), risk-free rate (c), systematic risk or beta (x) and market risk premium (a) are components of CAPM that are represented. SML is a line that shows the positive relationship of systematic risk and its expected return and identifies the level of return expected in the market for each level of share’s systematic risk or beta. Market equilibrium is achieved when supply equals demand and asset/ share prices remain stable. As an illustration, when one share is currently undervalued, rational investors would buy this share that will cause its price to rise and consequently driving its returns down (e.g. inverse relationship of price and return). The opposite scenario is also true for overvalued shares, that is, mis-pricing cannot last in the long-term.
In addition, there are several assumptions that CAPM is limited that should be tallied into the real world. One is that it relies on historic data (e.g. beta) to forecast future returns which are flawed as to predict future variability. Second is the inclusion of expectations and subjective judgments of investors in the model which is difficult to quantify. Third is the presence of perfect capital market where it is composed of several small rational investors and that financial markets have no transaction costs, no taxes and no limitations when it comes to investment. Fourth is that investors are fully diversified. Fifth is the complexity of deriving CAPM components. Lastly is the one-time horizon assumption in SML. However, even with these limitations, CAPM remains an expectational predictive tool particularly the aspect of relating risk to return and not just return per se which is often the investor’s stance.
Cadbury Schweppes: Application of CAPM
Operating for over 200 years, Cadbury is an international manufacturer and distributor of major confectionary and beverage brands (). In its 2005 financial performance, Cadbury achieved at least 6% revenue growth and increases in underlying profit (+12%), profit before tax (+9%) and cash flows (₤404 Million). It is also on the verge of acquiring Adams that performs strong and growth ahead of the intention and also sold its European Beverages for ₤1.26 Billion. Up to 2007, Cadbury is bounded by five main goals; namely, delivery of superior shareowner performance, profitably and significantly increasing global confectionary share, profitably secure and grow regional beverages share, ensure capabilities are best in class and nurture the trust of their colleagues and the communities which they do business.
Cadbury has the highest total dollar share for three brand categories such as chocolate, sugar and gum among competitors like Mars, Nestle and Hershey. Although, on individual category (e.g. gum), Cadbury is trailing. Confectionary and beverage markets are growing with the support of increasing global population, consumer health consciousness and product innovation. Its supplier is diverse around 40,000 and no more than 10% of its raw materials are from a single supplier. As a result, it is possible to avoid the impact of price fluctuations and discontinuity of supplies that may halt production facilities. Its core purpose is to deliver superior returns to investors but also admitted that the management is operating with other stakeholders (e.g. customers, employees, etc.).
Derivation of CAPM Components
To measure the total risk of a portfolio, correlation and covariance will be used ( 1999). The first step to do is to get the return of the portfolio. This is merely the sum of expected returns of single-asset multiplied with their proportional share in the investment amount. Say I have 00 and opted it to invest in stocks and bonds in two different companies. If I will invest 50:50 on each financial instrument, their earlier computed single-asset expected values should be reduced to 50% and be totaled. In the same manner, their earlier computed standard deviation should be reduced to 50% or their share of the 00 investment. However, the problem of the preceding statement is that the standard deviation or the risk could lead to inaccurate decision information. Due to complexity of two-factor and much of the multi-factor portfolio than single-asset, the procedure requires further information about stocks and securities. Are they positively, negatively or no relation at all? Due to this, the correlation (the underlined one) in the formula Varp =(w1 )2(σ1 )2+(w2 )2(σ2 )2+2(w1 w2 ρ12 σ1 σ2 ) should be determined if will be indicated by +, – or zero values ( 1999).
Business risk is related to operating features of a firm while financial risk is related to the strategies behind the capital structure of a firm ( 1999). The former is a type of risk that is outside the control of firms and hardly affected by certain tactics and strategies because business risk is very dynamic and uncertain. On the other hand, the latter involves factors within the scope of managerial control because it arises from borrowed funds the company is bound to pay unlike equity funds. However, they are both under the definition of systematic risk or inherent risks of companies that cannot be reduced by diversification strategies. Business risks includes example such as the sensitivity of competitive structure of an industry to changes in macroeconomic variables such as inflation and interest rates. On the other hand, the more debt a firm has a greater level of financial risk or inability to meet such obligation.
Valuation can come directly to the firm. This is referred to as business risk ( 2000). For example, its integration effort has indicators of failing (partly indicated in high employee turn-over from a proposed merger), thus, requires greater returns for the heightened risks of integration failure. On the other hand, electric utilities initially have relatively lower business risk compared to aggressive and expanding firms. This is so the expected earnings will not largely depart from the original due to business risks.
Lastly, financial risk basically provides valuation of investors that the firm can control ( 2000). By merely looking in its financial statements, an investor can decipher financial risk involve in his stock investment. In the similar manner, he can assume his position of its value. For example, in capital structuring, common stock price will be undervalued when the firm is over- or under-leveraged. Although leveraging is good for the health of the firm, this suggest relatively complex forecast of future earnings of investors. This may also mean that debt servicing requirements might not be met, and as a result, it can affect the dividend pay-out or long-term goals of investors in their stakes on the firm. In additional, the level and duration of loan repayments is taken into consideration to calculate financial risk. Another, leverage buy-outs can dramatically pull the price of common stock.
For example, every stock in London Stock Exchange is uncorrelated with every stock; the beta coefficient is zero ( 2006). In this case, it will be possible to hold a portfolio in LSE that has risk-free. Investors would be acting like a casino owner having to only wait at the end of the day to receive fees from the players. The owner will accumulate earnings without any risks in playing rather only responsible for maintaining the venue. With zero betas, game theory will not hold and stock markets will never exist as correlated risk is the source of all risk in the diversified portfolio. On individual assets, beta represents volatility and liquidity of the market place while on portfolio perspective it refers to investor’s level of risk adversity. Beta is estimated through times series analysis and linear regression models ( 2006) like estimating ninety trading days of simple returns used as estimators for covariance and variance. Negative betas can be derived by holding securities that move against the market, shorting stocks and putting on options.
However, betas are limited because they are only based on historical market data ( 2006). As such, future implications to investments cannot be inserted in the decision-making criteria. Variables are identified based on their past performance and any future or expected changes are not taken into consideration. In effect, investors that accept and address this limitation often lead to speculation for a possible war, major earthquake, political scandal and other stock market related events due to the inability of the beta to represent the overall perception of the market about the future trends. In effect, it can be said that the limitation of the beta caused the stock market bubbles and other economic crisis that adversely affected the lives of the people; both rich and poor as over-speculation in the market lead to distorting the real performance of the market rather mere expectations of market participants without any proven level of superior output.
Implications
As observed above, portfolio of stocks need to only consider systematic risk. This is because the total risk of their holdings is already diversified by investing in different firms; therefore, unsystematic risk becomes irrelevant. However, total risk becomes important when the company decided to hedge their risks by holding government bonds which is said to be risk-free asset. In this regard, focusing only on systematic risk is limited in gaining the minimum level of risk. In addition, when expected return is smaller than the whole market the security in question is underperforming while when it is smaller than the risk-free asset the trade-off between risk and return is not optimized. Cadbury Schweppes should consider these notes in investment decisions.
Conclusions
Like any decision-making strategy, corporate objectives should be initially emphasized. In this specific case, Cadbury Schweppes should center its concentration in the immediate and long-term financial gains/ looses of the replacement and its contribution to overall corporate objectives. On the verge of determining the rationality behind the replacement decision, there is a need for asset comparison between the old and potential machines which can only be derived in performance, dollar and timeframe terms. In this respect, appropriate valuation techniques (e.g. NPV, IRR, Equity Annuity Method, etc.) would be identified and selected with reference to corporate standards, conditions and legal provisions. On the other hand, decision-makers can be suggested to perform real option methods to eliminate the overly financial focus of budgeting. The reporter can solicit guide from his supervisor to determine the organizational hierarchy that can perform the method. After the monetary and non-monetary approaches to budgeting has been applied, the favored option would be provided with clear cash flow analysis including any depreciation, betas and other factors that can affect estimates. At the end, responsibilities will be distributed to respective staff and managers in order to monitor and carry out contingency actions until the life of the asset lapses.
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