1CORPORATE FINANCIAL MANAGEMENT Table of Contents Introduction................................................................................................................................2 Discussion..................................................................................................................................2 Security Market Line & Capital Market Line........................................................................2 Minimum Variance Portfolio Importance..............................................................................5 Relevancy of CAPM Equation...............................................................................................6 Conclusion..................................................................................................................................7 Reference....................................................................................................................................9
2CORPORATE FINANCIAL MANAGEMENT Introduction The management of corporate finance is the act or way of developing plans and making investment decisions, which affects the operations of business positively. It is consists of goals and plan setting for achieving it and then deciding best possible way for paying them. In this concern, capital budgeting is defined as the formal process that entity uses to evaluate potential expenditures or investments. It is related with decisions regarding current funds (Lee & Su, 2014). Therefore, this report includes the discussion regarding the way SML differs from CML. Further, discussion will be on MVP importance and lastly, relevancy of CAPM equation will be discussed. Discussion Security Market Line & Capital Market Line CML CML is graphically depicted line. This line represents linear relationship in between total amount of risk and expected return for efficient portfolios of risky as well as riskless securities. It is graphically representation of the expected return of the portfolios that is comprised of all the possible proportion between risk-free asset and market portfolios. There is complete diversification, carries only the systematic risk and expected market return is equal to expected return of the of market portfolio (Williams & Dobelman, 2017). Generally, the calculation of expected return of particular portfolio is done by following formula: “E(Rc) = y × E(RM) + (1 – y) × RF” In this y is the market portfolio proportion, “E(RM)”is “market portfolio’s expected return”,“(1-y)”is “risk-free asset’s proportion”and “Rf”is “risk free rate”. The return of non-leveraged portfolios can be equal or less than market return, but leveraged portfolio’s
3CORPORATE FINANCIAL MANAGEMENT return can significantly increase the return of market (Balteș & Dragoe 2017). The equation of CML can be as follows: E(Rc) = RF+ SDc E(RM) - RF SDM CML depicts all the possible portfolios combination that is comprised of various proportions of portfolio of market and the risk-free market. The efficient frontier helps in representing all the possible combinations of the efficient portfolios, consisting of only the risky assets in the different proportions. CML’s intercept point and the efficient frontier calls tangency or market portfolios. In case, if there is risk-averse or rational investor then higher risk will be expected only in the situation when there is proportionate increase in the return. It is from this particular standpoint, portfolio of tangency is considered to be the most efficient portfolio (Hong & Sraer, 2016). CML is graphically depicted below:
Paraphrase This Document
Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
4CORPORATE FINANCIAL MANAGEMENT SML In comparison to CML, SML is concerned with representing CAPM graphically, which helps in demonstrating relationship between required rate of the return on individual security, as systematic risk function, which is not diversifiable. It depicts various market systematic risks levels of different plotted marketable securities against market expected return at given period. In comparison to CML, in SML graph helps in describing non- efficient and efficient portfolios. For any given security, market risk premium determination is given where it is plotted on chart (Lee & Su, 2014). SML equation is stated below: “E(Ri) = Rf+ βi[E(RM) – Rf]” The primary differences in between the CML and SML is measurement of the risk. Further, measurement of risk of the CML is by standard deviation or total factor of risk. In case of SML, measurement of the risk is done by beta, which helps in finding out security’s contribution of risk for portfolio. The market is thought of as indicative index of market or the universal assets. The beta equals to one then in that situation stock is having same level of the risk as of market. If the beta is greater than one then in that situation it represents risky assets compared to market. If beta is less than one then it represents risk that is less than the market (Balteș & Dragoe, 2017). SML is graphically depicted below:
5CORPORATE FINANCIAL MANAGEMENT Minimum Variance Portfolio Importance MVP isdefinedasportfoliosof thesecurities,which helpstoreduceoverall portfolio’s price volatility. The term volatility is commonly used concept. MVP indicates the portfolio, which comprises of the individually risky assets. Further, these risky assets are being hedged, when their trading is done together. The outcome of this is lower possible risk for rate of expected rate of the return. MVP leverages of each individual asset’s risk with the offsetting of investment (Bodnar & Gupta, 2015). Therefore, it hedges total risk of portfolio for accepted level of risk in respect of expected portfolio return rate. MVP is the risk based approach for construction of portfolio. It means that rather than using return and risk information as in portfolio selection of Markowitz, the construction of portfolio is done with the help of using risk measures. The reason behind opting for risk-based approach by investors is that the future or expected returns are difficult for estimating. However, the risk is not easy to estimate. It lead towards more robust portfolio, which is less subject to the risk estimation (Bodnar, Mazur & Okhrin, 2017).
6CORPORATE FINANCIAL MANAGEMENT MVP is associated with modern theory of portfolio and efficient frontier. It is considered to be unique portfolio, which is on efficient frontier. Most of MVP varies from the traditional mix of portfolios of stocks and bonds. In comparison to investment in mix of the lower risks bonds and higher risks stocks, it is the blend of highly volatile securities with the lower correlation. The logic behind this is the fact that by combining set of the volatile securities that don’t move with each other, investor hedges against losses, while increasing the profit (Yang, Couillet & McKay, 2015). MVP is model of the portfolio, which is combination of investment that are volatile individually. However, most individuals perceives it as of having lower risk, when this is put together. MVP mixes investment with the lower level of correlation. This correlation helps to measure that how much two different investment moves with one another. Searching of exact correlation has the requirement of advanced knowledge of data and mathematics. However, when talked about MVP, this is good for learning about its utility. The application of MVP technique is considered to be most popular to create strategies of equity and investment fund as well as other similar uses (Xing, Hu & Yang, 2014). Relevancy of CAPM Equation Inthesubjectoffinance,CAPMismodelusedfortheoreticallydetermining appropriate rate of the return required of the asset and making decisions regarding adding of assets to the portfolios that is well-diversified. It helps in describing relationship in between asset’s expected return and systematic risk, especially stocks. Throughout finance, CAPM is used widely to price the securities that are risky and generating assets expected return, given cost of capital and risk of those particular assets (Ruffino, 2014). The CAPM formula is as follows: “ERi=Rf+βi(ERm−Rf)”
Secure Best Marks with AI Grader
Need help grading? Try our AI Grader for instant feedback on your assignments.
7CORPORATE FINANCIAL MANAGEMENT Investors expects for compensating for time value of the money and risk. The rate of risk-free rate in formula of CAPM accounts for time value of the money. Further, other components of formula of CAPM accounts for investor taking on the additional risk. Moreover, beta of the potential investment is the measure of total investment’s risk will add to the portfolio, which looks like market. In case, if the stock is risky than market, then beta will be greater than one. Further, when stock is having beta that is less than one then portfolio risk will be minimized (Alqisie & Alqurran, 2016). There are different benefits of CAPM over the other methods of calculating the required return. It takes consideration of only systematic risk. In this, there is diversification of portfolio by different investors, which helps to decrease the unsystematic risk. The technique of CAPM is considered as good equity cost calculating method in comparison to growth model of dividend (Lee, Cheng & Chong, 2016). However, rather than various benefits of CAPM, it is highly criticized for being unrealistic due to the assumption on which model is based. These assumptions includes that the investors generally holds diversified set of the portfolios, the transaction is in the terms of single-period horizon, there is perfect capital market and lastly, investors lends and borrows at risk-free rate of return (Bhattacharya, 2015). Conclusion Hence, this report reaches at the conclusion that CML is theoretical representation of different blend of risk-free asset and portfolio of market for given Share ratio. Its basis is drawn from CAPM and capital market theory. Generally analysts uses this to derive required return, which may be expected by the investors to take certain amount of risk in the portfolio. SML in comparison to CML is representing CAPM graphically for giving returns that are expected from market. This is better method for making comparison of two investments or
8CORPORATE FINANCIAL MANAGEMENT the securities. Although, this depends on the assumptions of the risk of market, risk-free rates and the coefficients of beta. Moreover, the report concludes that the MVP helps in depicting portfolio, which is well-diversified. It is consists of the risky assets, which are being hedge when traded together. This results into decrease level of risk for expected rate of the return. It ascertains lower bond of the efficient frontier. Further, despite of the criticism, CAPM is still relevant compared to the other equations.
9CORPORATE FINANCIAL MANAGEMENT Reference Alqisie, A., & Alqurran, T. (2016). Validity of Capital Assets Pricing Model (CAPM) (empiricalevidencesfromAmmanStockExchange).JournalofManagement Research,8(1), 207-223. Balteș, N., & Dragoe, A. G. M. (2017). Rentability and risk in trading financial titles on the Romanian capital market.Theoretical and Applied Economics,24(Special), 57-64. Bhattacharya, R. R. (2015). Capital asset pricing model. Bodnar, T., & Gupta, A. K. (2015). Robustness of the inference procedures for the global minimum variance portfolio weights in a skew-normal model.The European Journal of Finance,21(13-14), 1176-1194. Bodnar, T., Mazur, S., & Okhrin, Y. (2017). Bayesian estimation of the global minimum variance portfolio.European Journal of Operational Research,256(1), 292-307. Hong, H., & Sraer, D. A. (2016). Speculative betas.The Journal of Finance,71(5), 2095- 2144. Lee, H. S., Cheng, F. F., & Chong, S. C. (2016). Markowitz portfolio theory and capital asset pricing model for Kuala Lumpur stock exchange: A case revisited.International Journal of Economics and Financial Issues,6(3S), 59-65. Lee, M. C., & Su, L. E. (2014). Capital Market Line Based on Efficient Frontier of Portfolio withBorrowingandLendingRate.UniversalJournalofAccountingand Finance,2(4), 69-76. Ruffino, D. (2014). A robust capital asset pricing model.Available at SSRN 2355950.
Paraphrase This Document
Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
10CORPORATE FINANCIAL MANAGEMENT Williams,E. E., &Dobelman,J. A. (2017). CapitalMarketTheory, Efficiency,and Imperfections.World Scientific Book Chapters, 445-510. Xing, X., Hu, J., & Yang, Y. (2014). Robust minimum variance portfolio with L-infinity constraints.Journal of Banking & Finance,46, 107-117. Yang, L., Couillet, R., & McKay, M. R. (2015). A robust statistics approach to minimum variance portfolio optimization.IEEE Transactions on Signal Processing,63(24), 6684-6697.