Capital Asset Pricing Model
The primary role of capital market is allocation of ownership of the economy’s capital stock . Capital market theory extends portfolio theory and develops a model for pricing all risky assets. Capital asset pricing model (CAPM) allows determining the required rate of return for any risky asset. CAPM offers powerful and intuitive pleasing predictions about how to measure risk and the relation between expected return and risk. It is widely used in application such as estimating the cost of capital for firms and evaluating the performance of managed portfolio . CAPM has been the basis for calculating the required rate of return to the stockholders.
The capital asset pricing model considers the risk associated with reference to the beta of the stock. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the CAPM model to calculate the expected return of an asset based on its beta and expected market returns . The value of beta portrays the volatility of an individual stock compared to the market as a whole, where it presents the picture of how much an investor can expect a particular stock to increase or decrease in price compared to the movement of the market as a whole . The CAPM model calculates the risk and return with reference to the beta. This model too considers the risk premium added upon the risk free rate in the market. Mathematically, CAPM is defined as:
Ke = Rf + (Rm - Rf) x β
Where,
Rf – Risk Free Rate,
Rm – Market rate of return,
β – Beta value
Value of Beta is interpreted on the reference of value 1. Stocks having beta less than one are considered to be less volatile than the market. Stocks having beta more than one are considered to be volatile stocks compared to the market, and stocks with beta 1 are equally volatile with the market. In this model, the risk free rate is considered to be time value of money and beta for individual risk.
Modern theoretical approach towards CAPM
The modern portfolio theory states that portfolio diversification is one of the major tools to eliminate the risk. For CAPM, risk remains after diversification is market risk, which is measured by the extent to which a given security tends to fluctuate . The flaws are compensated by the arbitrage pricing model (ATP) and three factor model that too considers the unsystematic risk for consideration. Thus, academics these days are more focused upon these models rather CAPM.
CAPM and Risk-Return Relationship
The volatility can be effectively reduced without significant cost of diversifying; thus the investors should be compensated for the portion of volatility which is merely stock specific and has no impact on a well-diversified portfolio . The Capital Asset Pricing Model signifies the impact of risk factor upon the required rate of return of the investors. The model signifies that the impact of volatility reflected by beta should be reflected on the required rate of return of investors. Thus, CAPM- Risk Beta signifies the relationship between the risk return relationships.
CAPM and Firm’s cost of capital
Equity is one of the major sources of capital for any company. Equity or the owner’s capital has a huge impact on the overall cost of firm’s capital. Equity holders are the owners of the company thus the impact of capital combination is reflected in their required rate of return. Debt is considered as one of the riskier sources of firm’s capital. Hence, with the increase in debt the riskiness of the company too increases because of the fixed expenses liabilities associated with the project. The standard finance theory suggests that more will be the riskiness associated with the business; more will be the returns. More, the statement can be further stated that more the risk associated with the investment, more will be the expected return of the investors. Thus, it is inevitable that more we increase in the debt position of the company more will be the cost of equity with higher expectation of return according to the risk weight. The riskiness of the firm is associated with the beta calculation; through company’s returns compared to the market return. Since, this model reflects the overall riskiness of the firm associating it with the required rate of return for the investors. This model signifies discount factor to discount firm’s returns to find the net present value of the investment. Thus, this model keeps the good account of the pricing of the firm’s equity based upon the debt position and the expected return of equity holders in relation to the market rate of return.
CAPM relevance to Corporate Managers
Capital Asset Pricing Model has been one of the major concerns of the managers because through this model, they derive the required rate of return for the equity investors. Since stockholders are the owners of the company, it is the job of manager is to perform best to fulfill the wealth maximization objective of the finance. The investors here are the principal of the organization whereas the managers are the agents to perform the task. To perform the effective operation of organization, the managers require CAPM for the following reasons:
One of the effective models to find the intrinsic value of company’s stock is Dividend Discount Model. This model discounts all the future cash flows to allocate the net present value of the firm. For this reason, the managers must allocate the required rate of return of the investors in relation to the risk position of the firm and the market return on investment. Thus, CAPM provides the managers with the required rate of return for the investors through with they can find the intrinsic value of their stock. This has implication for all the corporate managers that they can derive the true value of their company on that date discounting the future performances. This helps managers to identify the strategies to keep organization standing in present context.
Market stock price has been one of the major performance indicators for corporate managers these days. Since the market value of company’s stock depends upon the demand and supply of stock, it is unrelated to some extent to the intrinsic value associated. For this, manager must compare the intrinsic value of stock based upon the rate of return suggest by this model and compare with the market price of the stock. If the market price is overvalued or undervalued, the firm can take several steps to bring it to the tradable range using the stock split or stock merge technique. This method is useful to find and maintain the firm’s position in the market. Through this, they can further plan the stock split and merger decision to drag the stock in tradable range as per preference of the investors to maintain the position of company in the capital market.
Corporate managers have implication of this model in terms of calculating equity on the equity generated by the firm. Company’s ROE is calculated from the financial data generated out of the performance of the company. Since, with reference to the CAPM model, managers have the account of required rate of return of the investors. They can further compare it with the return generated against the equity and compare the true position of the firm. The firm must take several measures to generate a better return to meet or exceed the shareholders expectation on the return. The met expectations are true success of company these days.
Thus, Capital Assets Pricing Model takes account of the riskiness and market rate of return to find the expected rate of return of the investors, which helps the company to formulate better policy to meet the required rate of return of the investors. Mangers can focus upon both the inside and outside situation of the firm through which they can have focus on the correct policy that best address the intention of the firm. Corporate managers can compare their return with the stockholder’s expectation and act accordingly to justify the wealth maximization desire of the investors. Managers can have these financial toolkits as their management mantra to work for the best interest of organization as well as the investors. This model carries the significant impact upon the profitability and returns of the firm.
Limitation of CAPM model
The CAPM is one of the important breakthrough in the field of corporate finance. As stated already under the topic of modern theoretical approach of CAPM that that portfolio diversification is one of the major tools to eliminate the risk and the risk that remains after diversification is market risk. This concept is very useful in the purpose of investment or for corporate because it relates to the fact that expected rate of return is related to the beta of the investment and projects the view regarding the way in which expected return on an assets have relation with beta of that particular assets. Corporate finance do make the use of CAPM because there exist some kind of relationship between the beta and the discount rate of the project and the discount rate is the function of the beta of the project. The discount rate is calculated as follows:
Discount rate = Risk-free rate + Beta × Equity market risk premium
Whatever be the explanation but CAPM is not free of limitations. CAPM fails to explain that the total outcomes about return on investments, assets or securities. CAPM is based on the assumption that there is no transaction cost and taxes. So with no transaction cost, the existence of capital market line is possible. But in reality, this is not correct assumption as every transaction bears one or other form of cost. So the investment would fall above or below the capital market line. In addition to the existence of tax affect the rate of return. The capital gain tax increases the transaction cost as well as different types of tax reduces the expected rate of return. That fact that different investors being subjected to different kinds of taxes will lead to difference in pricing of same kind of assets.
CAPM also assumes that all the investors have homogenous kind of expectations about the risk and return for a particular assets. But in reality there is a pool of investors with different expectations. Different investors have difference in expectations for risk and return with regard to same assets. CAPM too fails to justify its assumption of presence of several risk free assets of various maturity. Practically there is no any risk free assets. Even treasury bills will have one or other kind of risk associated like inflation and currency risk. CAPM is also based on the assumption that total risk of the investment is represented by the systematic risk of the assets represented by beta. But it is a clear fact that there are other kinds of risk to which the investors are exposed to other kinds of risk like liquidity risk, inflation risk etc. With all this limitation, there is enough room for arbitrage pricing model and three factor pricing model so the CAPM is becoming less popular these days and investors, managers and other stakeholders are turning away from CAPM.
Bibliography
Fama, E. F., 2001. Efficient Capital Markets: A review of theory and emperical works. s.l., Journal of Finance, pp. 383-428.
Fama, E. F. & Kenneth , F. R., 2004. The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspective, pp. 25 - 46.
ILSTU, 2001. Calculating and Interpreting Beta, s.l.: s.n.
Investopedia, 2014. Beta. [Online] Available at: http://www.investopedia.com/terms/b/beta.asp[Accessed 25 January 2014].
Wahlstrom, C., 2008. Beta: A statisticcal analysis of a stock's volatility , s.l.: IOWA State Univeristy.
Womack, K. et al., 2003. Understanding Risk and Return, the CAPM, and the Fama-French Three Factor Model, Dartmouth: Tuck School of Business.
Yahoo, 2014. CAOM. [Online] Available at: http://voices.yahoo.com/flaws-capital-asset-pricing-model-7006334.html?cat=3[Accessed 25 January 2014].
