FM14e PPT Ch06

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).

In capital market, people are always seeking for the best investment project. They want to use the least cost to earn the most money. In another way, people always try to find the connection between the risk of an investment and its expected return. Nowadays, the most widely used model is CAPM. CAPM is Capital Asset Pricing Model. CAPM was funded by Jack Treynor (1962), William Sharpe (1964), John Lintner (1965a, b) and Jan Mossin (1966) (Dempsey, 2013). And it is the birth of asset pricing theory. The term ‘CAPM’ illustrates that it can give a proper solution to find the connection between risk and the expected return of the market portfolio under uncertainty conditions (Brealey, Myers and Allen, 2011). It is important for some researchers to help their decision making in capital market. This essay contains four parts. This essay examines firstly is giving a summary theory of CAPM. The second part will talk about the CAPM’s uses and limitations in evaluating the potential investment in a firm’s shares. The third part will talk about limitations and how CAPM to be used as a source of discount rate in capital budgeting for the firm’s direct investments. The forth part will give a conclusion about this essay.

The weighted average cost of capital (WACC) is one of the most important figures in assessing a company’s financial health as it gives an insight into the cost of the financing, can be used as a hurdle rate for investment decisions, and acts as a measure to be minimized to find the best capital structure for the company (QFinance the Ultimate Financial Resource, 2011).   The WACC for the high-tech alternative is 9.056% and represents the rate of return that the investors of Guillermo Furniture require, weighted according to the proportion each element of debt and equity bear to the total pool of capital.   The Guillermo weighted mix of financing is 40% debt and 60% equity. This alternative produces a 12% return on equity, so with the WACC of 9.056%, it creates almost 3% additional value for its investors.

The Capital Assets Price Model (CAPM), is a model for pricing an individual security or a portfolio. Its basic function is to describe the relationship between risk and expected return, which is often used to estimate a cost of equity (Wikipedia, 2009). It serves as a model for determining the discount rate which is used in calculating net present value. The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk premium. The formula is:

=Weight of debt * Cost of debt + Weight of equity * Cost of equity.

The historical roots on Return on Investments (ROI) have an extensive historical background which involves the Du Pont system. It is significant to illustrate the major history behind the Return on Investments (ROI) and how the Du Pont system started. The purpose of the Return on Investment (ROI) is to evaluate the efficiency of an investment or compare the efficiency of various investments. In addition to (ROI) share the common class of profitability ratios. Several examples will show how Return on Investments (ROI) and the Du Pont system has established life-long formulas to help indicate growth or decline on financial investments.

The students should come to realize that the return-on-capital figures should be evaluated relative to a market-based benchmark, the weighted average cost of capital. Relative to the WACC calculated in case Exhibit 2, Home Depot is beating its benchmark (12.3 percent), while Lowe’s is below its benchmark (11.6 percent). The class may comment on the justification for differences in the cost-of-capital estimates for firms that appear so similar in their risk profiles.

Investment performance can be measured in many different ways. Tracking the investment’s return is a simple way of measuring investment

Chapter 1 Chapter 2 Chapter 3 Chapter 4 Chapter 5 Chapter 6 Chapter 7 Chapter 8 Chapter 9 Chapter 10 Chapter 11 Chapter 12 Chapter 13 Chapter 14 Chapter 15 Chapter 16 Chapter 17 Chapter 18 Chapter 19 Chapter 20 Chapter 21 Chapter 22 Chapter 23 Chapter 24 Chapter 25 Chapter 26 Chapter 27 Chapter 28 Chapter 29 Chapter 30 Chapter 31 The Corporation Introduction to Financial Statement Analysis Arbitrage and Financial Decision Making The Time Value of Money Interest Rates Investment Decision Rules Fundamentals of Capital Budgeting Valuing Bonds Valuing Stocks Capital Markets and the Pricing of Risk Optimal Portfolio Choice and the Capital Asset Pricing Model Estimating the Cost of Capital Investor Behavior and Capital Market

The goal is to obtain the raw ingredients – expected returns, standard deviations and correlations. Historical data are used for this purpose. As a rule of thumb, five years of daily data are probably right (one year should be the absolute minimum). Keep in mind the following: 1) make sure to use the adjusted close prices to calculate returns (so that you won’t have large, spurious negative returns due to dividend payments or splits), and 2) calculate log returns (so that you can aggregate daily returns to obtain holding period returns, if ever needed).

equivalency of net present value rates of return and internal rates of return that follow as a consequence is reviewed, again discussed in detail in [1], [2] and [3]. This foundation provides the critical model structure and valuation framework from which risk-adjusted discount rates and liability beta can be determined.

A company’s assets are financed by either debt or equity. The weighted average cost of capital measures the cost of capital of a company based on two elements. One is the cost of debt and the other is the cost of equity. By taking a weighted average, the interest the company has to pay for every dollar it finances can be seen. The project cost of capital is equal to the firms WACC. Its projects cost of capital depends on its risk, when the market risk of the project is similar to the average market risk of the firm’s investments. This is when its cost of capital is equivalent for a portfolio of all the firm’s securities. The most important assumption used in the value of a project is the average risk. This is where we assess the

Risk and return are the fundamental basis upon which investors make their decision whether or not they should invest in a particular investment. How they are related and the influence between the two, is the decision making process that all investors must weigh up. This essay will show how risk can influence risk premium, outlining their relationship and how risk and return are related.

In order to determine the appropriate amount of expected return, given any level of risk, we must use the most important and widely used tool of finance: Discounted Cash Flows. The projected cash flows are our measure of value, and the discount rate that we use on these cash flows takes care of the expected risk. The result is a number that tells us everything

Financial literature advocates the use of the Net Present Value method for the evaluation of investments. Its key parameter is the required rate of return on equity, which is to be calculated using the