Capital Asset Pricing Model (CAPM) PDF
Added on 2020-12-18
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Finance
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Business Finance
Table of ContentsINTRODUCTION...........................................................................................................................1CLIENTS FINANCIAL QUESTIONS...........................................................................................11.Capital asset pricing method and how it is used for evaluating whether the expected returnon asset is sufficient to compensate the investor for the risk it takes..........................................12. What is efficient capital market and why it is necessary for financial managers?..................23. Identifying the assumptions for dividend valuation model......................................................34.Explaining Net Present Value as a capital budgetary tool and how it is used for theevaluation of the investment........................................................................................................3CLIENTS INVESTMENTS............................................................................................................41. Evaluating the information whether to invest in securities or not...........................................42. Weighted average cost of capital for the company (WACC)..................................................43. Calculation of Net present value of two projects.....................................................................6CONCLUSION ...............................................................................................................................6REFERENCES................................................................................................................................8
INTRODUCTIONBusiness finance can be described as such business activities which are concerned withthe procurement and conservation of capital funds for the purpose of meeting financialrequirements and overall goals and objectives of a business enterprise (Al-Mutairi, Naser andSaeid, 2018). The present project report will cover the capital asset pricing model (CAPM) thathow it is used for evaluating whether the expected return on an asset is adequate to mitigate theinherent risk. It will higher what is an efficient capital market and why it is necessary forfinancial mangers. Further, it will show what is NPV along with calculations and dividendvaluation model.CLIENTS FINANCIAL QUESTIONS1.Capital asset pricing method and how it is used for evaluating whether the expected return onasset is sufficient to compensate the investor for the risk it takesIn simple words, capital asset pricing method (CAPM) demonstrates the relationshipbetween the systematic risk and the expected return for assets, especially stocks and shares. TheCAPM model is used very commonly for pricing the securities that are characterised by highrisk. It was found by Harry Markowitz in 1952. As per the theory of CAPM, the expected returnof specific security or stocks/portfolio is equal to the rate of risk free security plus a riskpremium. If the security does not match with the expected return, then the investor is advised tonot to make the investment in those securities (Capital Asset Pricing Model (CAPM), 2019). Formula of CAPM : Expected return = Risk free rate + (Market return – Risk free rate)* BetaThe model takes into consideration the responsiveness or sensitivity of assets to the nondiversified risk or systematic risk or market risk which is commonly represented by the symbolbeta (β). The theory of the model could be understood by taking an example. Lets assume thecurrent risk free rate is 6 % and the Australia stock exchange 200 is expected to yield 15% overthe next year. Now there is a company called ABC Ltd whose evaluation is required in terms ofits securities for the purpose of investment. It has ascertained that company's beta (systematicrisk) is 1.5 and the overall market has a beta which is 1. This shows that company has higher riskas compared to market which in turn shows that securities of this company will provide morereturn as compared to the overall market return which is 15%. 1
Expected return = 6% + (15%-6%)*1.5= 27.15%The above evaluation depicts that the investor by investing in the securities of ABS Ltdwill at least get 27.15% returns on its investment.2. What is efficient capital market and why it is necessary for financial managers?Capital market is a financial market in which the long term security usually for more thana year or equity shares and securities are bought and sold by the investors. Capital marketsprovides a platform where the wealth of investors/ savers are provided to those who utilises suchwealth for long term productive purpose. The players in the markets individuals, public financialinstitutions, government etc (Andor, Mohanty and Toth, 2015). A capital market is said to be efficient when the securities are priced in accordance withtheir value given all publicly available information. Capital market efficiency analyse how much,how quick and how accurately the information which is available publicly is incorporated intothe prices of securities. There are three categories in which this available information iscategorised. These are :weak : In weak form efficiency, the prices of securities reflects the information containedin the past returns and prices. Semi-strong : In this type of efficiency, the prices of securities totally reflect all thepublic information. This means that only those investors such as corporate insiders whohave insights of companies and secret information are able to earn profits on the stockexchangestrong : In strong form of efficiency, the prices of securities reflects all the informationpossible even the most confidential one. This means that no investors can make excessprofits in the capital market.Efficiency of the capital market is important to financial mangers because the effect ofmanagement of the companies is shown their respective share prices which decides the valuationof the company in the market. Also, when the share price of a company is low, the financialmanger is restricted in raising and allocating its funds more optimally because investors do notshow much trust in the company whose securities prices are lower. This is because the investorfeels that company will not provide good returns if they invest in such company (EfficientCapital Market, 2002). 2
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