Evaluation of Risk and Return Measures using CAPM Model

This report analyzes the risk and return measures of a company using the Capital Asset Pricing Model (CAPM). It explains the relation between risk and return, the calculation of beta for individual securities, and the diversification of portfolios to minimize risk and increase return. The report concludes that the case company has more risk than a hypothetical company, but also has the potential for higher returns. The use of CAPM has led to the foundation of a well-diversified portfolio that minimizes risk and increases return for investors.

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ACC00716 Finance Session 1, 2018
Assessment 2: Business Case Studies 1

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Introduction
The report incorporates the use of Capital Asset Pricing Model (CAPM) and the context
of the company for gaining an analysis of the risk and return measures of parts 2(a) and 2(b). The
interpretation of the above parts can be carried out precisely through the use of CPAM model
that is used to gain an understanding of the relation between risk and return.
Evaluation of the risk and return measures of parts 2(a) and part 2(b) in context of
Company and CAPM Model
Capital Asset Pricing Model (CAPM) develop by William Sharpe is often finding
extensive use by the investors for developing an understanding of the systematic risk and the
expected return of a financial asset. The model was used by the investors in particular for
determining the potential worth of their investment and thus taking accurate investment
decisions. The most significant advantage of the use of this model by the investors in comparison
to other models is that it helps in assessing the systematic risk of an investment that other models
are not able to calculate. There are two types of risk impacting the return on investment of an
investors, these are, systematic and unsystematic risk. Systematic risk can be regarded as market
risk that cannot be reduced or diversified by the investors as it is present in the market conditions
and thus cannot be completely eliminated. It depends on the volatility of the market due to daily
changes in the prices of stocks (Peterson and Fabozzi, 2002). On the other hand, unsystematic
risk is the type of risk that can be diversified and is associated with a particular company or
industry of investment. Thus, calculation of systematic risk in addition to unsystematic risk is
essential to the investors to gain an analysis of the expected returns to be realized from a

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security. CAPM model assesses the systematic risk associated with an individual security
through the calculation of beta depicted in its formula as follows:
ra = rrf + Ba (rm-rrf)
where:
rrf = risk-free security rate of return
rm = expected rate of market return
Ba = beta. i.e. systematic risk associated with an asset
The use of the above formula is very helpful in assessing the fair price of an investment
so that it can be compared to the market price. Thus, if the fair value is higher than the market
price then only an investment can be considered to be worthy of investing otherwise not. The
model is extremely helpful in reducing the systematic and unsystematic risk through
diversification and investing in assets having lower systematic risk. The model is used for
analyzing and computing the expected return of Boral (BLD) through the help of evaluation of
the risk-factor, that is, beta of the company. The beta risk cannot be reduced or eliminated due to
presence of uncertainty in the market. The expected return is mainly impacted by the beta factor
as rate of return on risk-free assets and the market return are relatively same for all the
companies that are listed under a particular market index. Therefore, the calculation of the beta
factor will help in assessing the expected run to be realized from the company. The calculation of
the expected return from the company requires the computation of risk-free return, market risk
premium and the beta (Weston and Brigham, 2015).

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As calculated in the previous question, the risk-free rate of return is 4.10 based on the
return of the Australian treasury bonds for 10 years. The market risk of the company and the
hypothetical company is 6.50%. As such, the risk-free rate of return and the market risk premium
of the company in context and that of hypothetical company is 3.2 % and 6.5%. Beta for
hypothetical company as given is -0.25 and the beta of the company in context as extracted from
the use of yahoo finance is 1.17 (Yahoo Finance, 2018). This indicates that expected return of
the case company will increase from 1.17 will the rise of the stock market with 1 basis and will
fall in the negative direction with the reduction of market by 1 basis point. Therefore, it can be
stated from the overall discussion that the case company selected has more risk in comparison to
the given hypothetical company. However, there are also chances for the investors to realize
higher returns in future from investing in the risky assets of the case company. This is because
higher beta indicates higher risk which is indicative of realizing higher returns as provided in the
CAPM model. However, there is use of proper management technique by the investors to
manage the investors for ensuring that they gain higher returns from investing in the stocks of the
case company.
Thus, it can be said on the basis of CAPM model that there exist a positive relation
between risk and the expected returns of securities. This can be cited as a major reason for the
case company for providing higher returns in comparison to the hypothetical company. The cost
of equity of the company can also be determined through the use of beta. This is possible as
stock indicates equity and therefore the calculation of the expected return from individual stocks
determines the cost of equity of the overall company (Reilly and Brown, 2011).

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The use of CAPM model has laid to the foundation of a well-diversified portfolio that
minimizes risk and increases return for investors. The portfolio will consist of 50% of the stock
of the case company and other 50% of the hypothetical company. The application of the CAPM
model has calculated the beta of portfolio to be 0.46 while the expected return is 7.09%. The
expected return of portfolio is higher than that of individual return of case company. This is
because the portfolio have been diversified that reduce risk through the use of a risky and low-
risky asset.
Conclusion
CAPM model has provided a sufficient explanation of the risk and return measures of the
parts 2(a) and 2(b).

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References
Peterson, P,P and Fabozzi,F,J,. 2002. Capital budgeting: theory and practice. John Wiley & sons.
Reilly.F.K. and Brown.K.C. 2011. Investment analysis & portfolio management. South western
Cengage learning.
Weston, J.F. and Brigham, E.F., 2015. Managerial finance. Hinsdale, IL: Dryden Press.
Yahoo Finance. 2018. Boral. [Online]. Available at: https://finance.yahoo.com/quote/bld.ax?
ltr=1 [Accessed on: 19 April 2018].