CAPM and Sources of Capital: A Study Guide

2) In the real world, it is not possible to construct a portfolio of stocks with an expected return equal to the risk-free rate. If CAPM is considered, the stock would need to have no market risk premium and no company-specific risk either. Such a portfolio would need to have a beta of zero. There are few companies with a negative beta, which would be required to construct such a portfolio. If such a

We use Capital Asset Pricing Model (CAPM) approach to calculate the cost of equity. The formula of CAPM is re = rf + β × (E[RMkt] – rf).

Explain the advantages and disadvantages to use the CAPM model as the method to compute the cost of common equity. Compare and contrast

Given these approximations, the CAPM model would total the risk-free rate and the market risk premium times beta to arrive at a cost of equity of 9.68%, which reflects the investors’ expected return from investing in shares of the company.

The regression that we performed in excel for both stocks yielded a beta of .73576 for Reynolds, and a beta of 1.4198 for Hasbro. In question 2 we learned that although Reynolds stock was riskier independently, adding it to the portfolio made it more diversified compared to adding Hasbro, due to the fact that it was less correlated to the market portfolio. Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Therefore, since the beta of Reynolds is lower than Hasbro, our beta calculations align with the fact that Reynolds stock makes the overall portfolio less risky. This finding is also intuitive when considering the nature of the companies; Reynolds is a Tobacco company meaning that is should be less sensitive to changes in market conditions than a toy company like Hasbro.

Capital asset pricing model or CAPM is a financial model that measures the risk premium inherent in equity investments like common stocks while Discounted Cash Flow or DCF compares the cost of an investment with the present value of future cash flows generated by the investment with the mindset being that if the cash flow is positive, then the investment is good. Generally speaking, CAPM is a model that describes the relationship between risk and expected return and DCF is a valuation method used to estimate the attractiveness of an investment opportunity. So what are the differences, advantages and disadvantages of each one? How

Utilizing the fundamental concepts of the Capital Asset Pricing Model (CAPM), the expected return for Wal-Mart stock is 7.01% [E(R)]. This is a result of a risk-free rate (Rf) of 3.68%, which was the provided 10-year government bond yield to use as a proxy for the risk-free rate. The beta (β ) of Wal-Mart was 0.66 according to the provided Bloomberg beta estimate. Additional data was provided on the U.S. market risk premium [E(RM) – Rf] of 5.05%. In following the general concepts of CAPM, there are some general assumptions: no transaction costs, all assets are publicly traded,

CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.

A common practice to determine the firm’s beta is to draw from historical data from published sources or compare numbers to competitors. In this case, Heinz can compare to Kraft, Campbell Soup and Del Monte and use professional judgement in determining the stock’s sensitivity to the market. A stock’s beta can be determined using a formula as well.

‘The Capital asset pricing model (CAPM) is a very useful model and it is used widely in the industry even though it is based on very strong assumptions. Discuss in the light of recent developments in the area.’

CAPM on the other hand is based on microeconomic ideas such as concave utilities and costless diversification. Macroeconomic events mentioned include interest rates or the cost of labor, causes the systematic risk that affects the returns of all stocks. On the other hand the firm-specific events are the unexpected microeconomic events that affect the returns of specific firms for example the death of key people that would affects the firm, but would have a insignificant effect on the

BROTHERSON ET AL. – “BEST PRACTICES” IN ESTIMATING THE COST OF CAPITAL: AN UPDATE 15 “Best Practices” in Estimating the Cost of Capital: An Update W. Todd Brotherson, Kenneth M. Eades, Robert S. Harris, and Robert C. Higgins “Cost of capital is so critical to things we do, and CAPM has so many holes in it—and the books don’t tell you which numbers to use… so at the end of the day, you wonder a bit if you’ve got a solid number. Am I fooling myself with this Theories on cost of capital have been around for decades. Unfortunately for practice, the academic discussions typically stop at a high level of generality, leaving important questions This paper updates our earlier work on the state of the art in cost of capital

Even though there are flaws in the CAPM for empirical study, the approach of the linearity of expected return and risk is readily relevant. As Fama & French (2004:20) stated “… Markowitz’s portfolio model … is nevertheless a theoretical tour de force.” It could be seen that the study of this paper may possibly justify Fama & French’s study that stated the CAPM is insufficient in interpreting the expected return with respect to risk. This is due to the failure of considering the other market factors that would affect the stock price.

According to economic theorist, the problem regarding the cost of capital emerge is because capital that used to obtain assets create uncertain profits. In perfect capital market, we assume that firms act rationally; therefore theorist has come out with a proposition that helps to make the marginal profit on physical assets equal to the market rate of interest. Two propositions have been introduced and both of them are assuming that firm, as a rational decision maker under certainty circumstance will maximize profits and market value of their firm. As an addition, cost of capital will be equal to the rate of interest of bond and this is applicable for any type of financial structure. Economic theorist also assumes that firms can be

Several elements and factors about financial and social environment risk should be considered when a portfolio is chosen. In this section, we present the nature and classification of risk in the impact investment portfolio.