Financial Management For Capital Asset Pricing Model

Discussion

Discuss about the Financial Management for Capital Asset Pricing Model.

In financial management, one of the most significant components is managing the portfolio for investment purpose. However, the investors must require to have good knowledge for optimum investment that considers the factors of risk, return, nature and timing of investment. For this purpose, Capital Asset Pricing Model (CAPM) is the most common and essential model that is used to determine the expected return on investment. It represents the equation, which specifies market risk, government risk-free rate, market rate premium to generate the expected return for the investors (Barberis et al. 2015). The model reflects the expected rate of return by considering the essential elements of finance i.e. market risk, market premium and risk free rate of return. It is represented graphically by using “Capital Market Line and Security Market Line” to measure the relationship between risk and price of the securities. It is used for budgeting investment capital by the business organizations that determine the expected return and thereby determine the net present value from the proposed investment (Almeida et al. 2016).

Capital Asset Pricing Model (CAPM) is used to measure a required rate of return on acquisition of an asset that assists in making investment decisions for an optimum portfolio management. The model is used to determine the cost of equity by considering the risk factor called beta of the stock (de Azevedo et al. 2015). The model uses a formula to determine a linear relationship between the required or expected return on the investments and the potential systematic risk on the securities trading on the stock exchange market. The method is also used to measure the return and risk factor for the investments to be made in the business organizations. The risk and return of the investment is measured by using the CAPM formula “E (ri) = Rf + β (E (rm) – Rf)” where E (ri) represents required return on investment (i), Rf represents risk-free return, β is the risk factor of the investment (i) and E (rm) represents the capital market return at an average rate (Júnior et al. 2016). 

The CAPM theory is based on certain assumptions indicated on investors’ requirements and expectations. First assumption of the theory is that the aim of all the investors is to maximize the economic values and therefore investment assets are fixed in nature and quantity. Second assumption of the theory is that all the investors are reluctant to take risk hence they hold diversified investments to minimize the systematic risk while the unsystematic risk has been ignored. Third assumption is based on the ability of the investors to influence the price of the assets. It means that the capital market is perfect and investors are not able to influence the price of the securities (Andonov, Eichholtz and Kok 2015). Further, the CAM model does not consider the factor of tax costs, transaction costs and all the securities are graphed on the same “Security Market Line”. It has also been assumed that there is equal amount of information available to the asset holders as well as they have equal expectations with respect to the returns on investment. For the purpose of portfolio investment CAPM model also assumes that the asset holders have the choice of borrowing and lending investing money at risk-free return (Novak 2015).

Advantages of CAPM

The two significant components of the CAM model is Security Market Line and Capital Market Line that are represented on a graph to measure the factors involved in the investment. The Security Market Line (SML) represents the various level of market risk of financial assets or securities drawn against the market expected return at a point of time. It is also known as “characteristic line” which is disclosed by the terms of risk i.e. beta on the x-axis as well as the expected return on y-axis (Bhala, Yeh and Bhala 2016). On the other hand, Capital Market Line (CML) represents the expected return rates for the competent investments or securities subjected to the risk on market return and risk-free return. SML measures the expected market risk and return at a particular time while CML represents the relation between required return on risk free investments and the risk levels for a particular portfolio (Mao and Zhu 2015).

The slope of Capital Market Line is measured by using the Sharpe Ratio which is stated as Expected return deducted by the risk-free rate of return whole divided by standard deviation. On the contrary, SML defines the function between expected return and market risk. For instance, real risk- free rate of a security is 6.00% and market risk premium i.e. (rm – rf) is 5%, accordingly the SML will be represented as E (ri) = rf + β (rm – rf) i.e. E (ri) = 6 + 5β.

CAPM is one of the most celebrated models in financial management that assists the investors in managing the investment portfolio, analysis of equity stocks and capital budgeting. One of the essential advantages of CAPM model is the use of systematic risk that is the volatility of stocks on account of economy and effects all the securities in the same direction with unequal sensitivity (Uthman et al. 2015). Another advantage of using this model is derivation of relationship within the return on securities required by the investors and risk on securities as per market ignoring all other factors. Since the model considers the economic market risk therefore, it is advantageous to determine the equity cost using CAPM model. It also provides clear and unambiguous result on investment return, risk and cost of securities over other models of financial management (Kahn and Lemmon 2016).

Besides, it is argued by many theorists that the CAPM model lacks the use of various important financial and investment elements that reflects several disadvantages of the model. The model considers risk free rate of return to measure the other variables of securities which is a yield on government bonds that are of short term period. Since the yield on securities change on daily basis concerning the risk and deviation, using the fixed rate of return would not determine the correct value of the equity cost, risk or expect return. Further, derivation of expected return on equity is difficult because the market return is a derivation from the average capital gain and dividend in the stock market that can be negative in the short term. It happens due to fall in price of securities and the expected return is not stable at a given point of time (Brown, Tian and Tucker 2015). Moreover, the model use the assumption of borrowing at risk- free rate which reveals unrealistic report because individuals are not able to borrow at the risk free rate. Therefore, investors are bound to incur borrowing charges at higher rates that eventually lowers the expected return on investments. Considering the other assumptions, the CAPM ignores the tax costs, transaction costs and other relevant charges while determining the expected return of the securities. In the present market economy, taxation and other charges are the most significant charges that the investors are required to pay on their income (Bravo, Cacha and Quiñones 2015). Hence, avoiding these charges and cost factors, correct results of the expected return, investment risks and cost is difficult to ascertain.

Disadvantages of CAPM

Despite of several criticisms, CAPM is utilized in various financial decisions by the organizations as well as by the individual investors. One of the important corporate decision is capital budgeting that requires an optimum decision for proposed capital investment for the purpose of business expansion. For this purpose, CAPM determines the rate of return that companies expect from proposed investment. It is measured by computing beta i.e. potential risk from the equivalent trading firms. For instance, Beta of the similar form in the industry is β = 1.6, rf= 6%, E (rm) = 14%, therefore hurdle rate E (r project) = 0.06 + 1.6 (0.14- 0.06) = 18.8%. Using the expected return derived by using the CAPM model, the company determines the Net Present Value of the project proposed to be invested for. The model also serves the purpose to equate the value of equity and analyze the securities investment by the companies (Thijssen and Delaney 2015). It is regulated for the specific project to establish fair reimburse for the investments that affects the monopoly business and companies that involves the annual profit factor risk factors. CAPM model is also used in the measurement of investment portfolio diversification that determines the risk in the investment, return to be earned from the investment in financial securities. Moreover, the model considers the systematic risk related to the market industry, which cannot be diversified by the investors. Since the market risk is unavoidable by the investing companies and individuals, the CAPM model does not consider unsystematic risk because it specific to the particular investment that can be avoided. Accordingly, investor companies or individuals use CAPM model to determine their expected return by considering the market risk and risk- free government bonds (de Castro Dias, da Cunha and da Silva 2016).

In view of the “Capital Asset Pricing Model (CAPM)”, it can be said that even though the model has several criticism, it is still the optimum model to measure the expected return rate and risk factor of the investors. It is recommended that the model can be used if the investors plan to invest in a specific investment securities to determine the potential return and risk elements. Further, if the investors are likely to invest for short- term period preferably one year, then the CAPM model is can be used to measure the expected rate of return with accuracy. Since the model prefers the borrowing amount at risk-free rate investors can avail government bonds for acquiring funds to invest in equity securities (Bhala, Yeh and Bhala 2016). In this situation, investors are also not liable for tax cost and other charges because the investment is for short- term period and does not involve transaction cost and other financial charges. Therefore, the investors are able to measure correct expected return on investments and capital budgeting purpose. The CAPM model uses the assumption to ascertain the rate of return in a market that is perfectly competitive, therefore in order to determine the expected return, investors are recommended to acquire securities from open market. Company investors and individual investors are recommended to invest through the securities from stock exchange market to avoid the differential risk elements. In order to avoid further risk and maximize the expected return on investments, investors may invest in diversified securities by creating optimum portfolio management. Such diversification would enable the investors to minimize the risk factor because the unsystematic risk i.e. securities risk varies from specific company to company.

Application of CAPM in Capital Budgeting

Conclusion

It is concluded from the above discussion that CAPM reflects different approach to measure the elements of risk and return in an investment. It assists in determining the financial decision using capital budgeting, portfolio management and equity stock valuation. The model is used o determine the expected return of the investment by considering the elements of risk, market premium and government return rate. The model uses various assumptions that are criticized by theorists based on the borrowing or lending rates, period of investment, cost of investment etc., which does not provide the expected return based on the realistic picture. Corporate investors require to measure the rate of return, net benefit and loss as well as the potential risk from the proposed investment. Such measurement can be ascertained through CAPM model but it does not consider the tax cost and other transaction cost. As per the present scenario, taxation cost plays an important role for the investors’ income hence; ignoring the taxation cost would not reflect the correct return. Besides, the model considers the entire market risk which is unavoidable and significant to evaluate the net income from investment. The model also considers the risk- free government bond rate while measuring the rate of return that are issued for short- term period. Therefore, it is the best model to be used for the specific investment in the short- term period since it considers the total market risk for investment companies and individuals.

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