SESSION 12 CAPITAL ASSET PRICING MODEL

1201
OVERVIEW
Objective
To understand the Capital Asset Pricing Model and its uses in financial management.


BETA FACTORS
USES OF THE
CAPM
Measurement
Calculation
Interpretation
Formula
Security Market Line
Well-diversified investor
Companies
Asset betas
Equity betas
Use of the equity beta
ASSUMPTIONS
AND
LIMITATIONS
CAPITAL ASSET
PRICING MODEL
DEGEARING AND
REGEARING BETA
Project appraisal in a new
industry
MM and betas
Assumptions
Limitations
SYSTEMATIC AND
UNSYSTEMATIC
RISK
Definitions
Measurement of systematic risk






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1 SYSTEMATIC AND UNSYSTEMATIC RISK
1.1 Definitions
Risk, the variability of returns, can be split into two elements:
unsystematic risk These are the risks that are unique to each companys shares;
It is the element of risk that can be potentially eliminated by
shareholders building a diversified portfolio.
It is also known as unique or industry-specific risk
systematic risk These are the risks that affect the market as a whole rather than
specific company shares;
This cannot be diversified away;
Therefore systematic risk still remains even in a well-diversified
portfolio;
This is also known as market risk.
1.2 Measurement of systematic risk
A well-diversified portfolio of shares still has some degree of risk or variability. This is
due to the fact that all shares are affected by systematic risk i.e. to macro-economic
changes.
Systematic risk will affect the shares of all companies although some will be affected to
a greater or lesser degree than others.
This sensitivity to systematic risk is measured by a beta factor.
2 BETA FACTORS
2.1 Measurement
Beta factors for quoted shares are measured using historic data and published inbeta
books. They are determined by comparing changes in a shares returns to changes in
the stock market returns over a period of many years (5 years data should be used at
least)
This can be illustrated by the Security Characteristic Line which gives an indication of
the shares sensitivity to market changes.
The beta factor is estimated from these observations by determining the gradient or
slope of the line of best fit through the observed points. The steeper the slope the
more volatile the share and the higher the beta factor.
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(Ri - Rf)
Security characteristic line
Intercept =
Slope =
(Rm - Rf)

Where (Ri Rf) = the excess return of the share over the risk free return
(Rm Rf) = the excess return of the stock market over the risk free return
Rf = the return on a risk-free investment
The Security Characteristic Line should in the long run pass through the point where
the two axes meet.
However in the short run this may not always be the case and any short term difference,
or abnormal return, is known as the alpha factor.
2.2 Calculation
A beta factor for a share i can also be calculated using linear regression:
Bi =
returns s market' the of Variance
market the with i of Covariance

Or
Correlation of the share with the market standard deviation of the shares returns
Standard deviation of the markets returns

Example 1

A share has a standard deviation of 15% and a correlation coefficient with the
market returns of 0.72. The standard deviation of the market is 21%.
What is the shares beta factor?


Solution
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2.3 Interpretation
A beta factor therefore simply describes a shares degree of sensitivity to changes in the
markets returns, caused by systematic risk.
Beta factor of 1 this indicates that the share is as sensitive as the market to
systematic risk
Beta factor > 1 this means that the share is more sensitive than the market.
Therefore if the market in general rises by 10% then the returns
from this share are likely to be more than 10%.
Beta factor < 1 the share is less sensitive than the market and is likely to rise and
fall in value less than the market in general.
3 CAPITAL ASSET PRICING MODEL
3.1 Formula
If the shareholders of a company hold well-diversified portfolios then they are
concerned only with systematic risk.
The return these shareholders require therefore is only a return to cover the systematic
risk of an investment.
Systematic risk is measured by a beta factor - therefore the required return from an
investment must be related to the beta factor of that investment.
This is brought together in the Capital Asset Pricing Model which is a formula that
relates required returns to beta factors as measures of systematic risk.
The CAPM formula is :
E(r
i
) = Rf + i(E(r
m
)R
f
)
E(r
i
) = expected/required return from an investment
Rf = risk free return
E(r
m
) = expected return from the market portfolio
=
beta of the investment
The Market Portfolio is a portfolio containing every share on the stock market.
CAPM is the equation of the Security Market Line

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3.2 Security Market Line
The Security Market Line is a graph that indicates the required return from any
investment given its beta factor. Forecast returns from investments can be compared to
the figure from the security market line to indicate whether that investment is under or
over valued.
Return
Rm
Rf
x Ra
x Rb
Security market line
Beta
0 Ba 1 Bb

Where Ra = the forecast return from investment A
The required return of an investment with a beta of zero (risk free) will be the risk free
return.
The required return of an investment with a beta of 1 will be the market return.
Consider investment A - it is forecast to earn higher returns than the CAPM would
predict given its beta. It is therefore temporarily under-priced. This is referred to as a
positive alpha investment.
Consider investment B - it would appear to be temporarily over priced a negative
alpha investment.
In the long run market forces should ensure that all investments do give the returns
predicted by the Security Market Line.
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4 USES OF THE CAPM
4.1 Well-diversified investors
If an investor already holds a well-diversified portfolio then that investor will be
concerned only with systematic risk. The CAPM is therefore relevant.
The investor will be satisfied only if a potential investment gives a high enough return
given its sensitivity to market risk as measured by its beta factor.

Example 2

An investment has an forecast return over the next year of 12%. The beta of the
investment is estimated at 0.9. The risk free rate is 5% and the market return is
15%.
Should a well-diversified investor buy this investment?


Solution



4.2 Companies
Companies should not diversify their activities simply to reduce the risk of their
shareholders. Shareholders can diversify their shareholdings much more easily than a
company can diversify its activities.
If shareholders are already well-diversified then the company should concern itself, on
behalf of the shareholders, simply with the systematic risk of potential projects.
Therefore the aim of a company, with well-diversified shareholders, should be to
determine the required return from its investment projects and then compare this to the
forecast return.
If the project is the same risk as that of the existing activities of the company then the
existing WACC can be used.
However if the project is of a different risk type to the existing activities then the
existing WACC will not be appropriate. In these instances a tailor-made discount rate
for that type of project must be determined using the CAPM.
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4.3 Asset betas
Any company is made up of its assets or activities. These assets will have a certain
amount of risk depending upon their nature. These assets will have a beta factor that
recognises the sensitivity of such assets to systematic risk.
This beta factor is the asset beta and measures the systematic business risk of the
company.
It can also be referred to as an ungeared beta factor
4.4 Equity betas
The equity beta measures the sensitivity to systematic risk of the returns to the equity
shareholders in a company.
In an all-equity financed company, or ungeared company, the only risk that is incurred
is business risk.
Therefore in an ungeared company the asset beta and the equity beta are the same.
However in a geared company the equity shareholders face not only business risk,
measured by the asset beta, but also a degree of financial risk.
Therefore in a geared company the equity beta > the asset beta.
Equity betas can also be called geared betas.
4.5 Use of the equity beta
The equity beta measures the sensitivity to market risks of the equity shareholders
returns. If the equity beta is used in the CAPM this gives the required return for the
equity shareholders.
The required return of shareholders = the cost of equity geared (Keg)
The CAPM can therefore be used as an alternative to the Dividend Valuation Model for
estimating the cost of equity of a company.
Example 3

The equity beta of a company is estimated to be 1.2. The risk free return is 7%
and the return from the market is 15%.
Estimate the cost of equity of the company?


Solution

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5 DEGEARING AND REGEARING BETA
5.1 Project appraisal in a new industry
It has already been noted that a companys existing WACC is only a relevant discount
rate for a project with the same level of business risk as existing activities..
If the project is in a different industry (or country) then a discount rate to reflect the
business risk of that industry is required.
A company in a similar industry can be found and its beta discovered. If that company
is geared then its equity beta will contain both business risk and financial risk.
However that company will probably have a different level of gearing compared to our
company.
This requires us to first degear the beta to find the asset beta, and then regear to
reflect our companys level of financial risk
5.2 MM and betas
The following formula (based on Modigliani and Millers models) can be used to
convert an equity beta to an asset beta (and vice-versa):

a =
( ) ( )

+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )

+

d
T 1 Vd Ve
T 1 Vd


where a = asset beta
e = equity beta
d = beta of corporate debt
Ve = market value of equity
Vd= market value of debt
T = corporation tax rate
If the exam question does not give a beta factor for debt then assume that debt is risk
free i.e. d = 0
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Example 4

A plc produces electronic components but is considering venturing into the
manufacture of computers. A plc is ungeared with an equity beta of 0.8.
The average equity beta of computer manufacturers is 1.4 and the average
gearing ratio is 1:4.
The risk free return is 5%, the market return 12% and the rate of Corporation
Tax 33%.
If A plc is to remain an equity financed company what discount rate should it
use to appraise a computer manufacture project?


Solution







Example 5

Suppose that A plc from the previous example has a gearing ratio of 1:2. It still
wishes to enter into the same computer manufacturing project.
What is the discount rate that should be used for A plc for a computer
manufacturing project?


Solution

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6 ASSUMPTIONS AND LIMITATIONS OF THE CAPM
6.1 Assumptions
total risk can be split between systematic risk and unsystematic risk;
unsystematic risk can be completely diversified away;
all of a companys shareholders hold well-diversified portfolios
a risk-free security exists;
perfect capital markets.

6.2 Limitations
it is a single period model;
it is a single index model - beta being the only variable to explain different required
returns on different investments.
Lack of data for the model particularly in developing markets
CAPM tends to over-state the required return on very high risk companies and under-
state the returns on very low risk companies.
Many of the assumptions do not hold in real life

Key points

CAPM is an alternative to the Dividend Valuation Model (DVM) for
estimating a companys cost of equity.
Beta factors measure systematic risk and therefore CAPM should only be
used if the companys shareholders have themselves used portfolio theory
to diversify way unsystematic risk
Despite its assumptions and limitations CAPM is a more flexible model
than DVM as it allows the estimation of project-specific discount rates


FOCUS
You should now be able to:

understand the meaning and significance of systematic and unsystematic risk;
appreciate the uses of the CAPM for financial management;
discuss the assumptions and limitations of CAPM.
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EXAMPLE SOLUTIONS
Solution 1
Beta factor =
21
15 72 . 0

= 0.51
Solution 2
Required return = 5 + 0.9 (15 5)
= 14%
Expected return = 12%
Therefore the investor should not invest.
Solution 3
Ke = 7 + 1.2 (15 7)
= 16.6%
Solution 4
Using MM formula find the asset beta of the computer industry:
a =
( ) ( )

+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )

+

d
T 1 Vd Ve
T 1 Vd

Ba = 4 . 1
) 67 . 0 1 ( 4
4
+

Asset beta = 1.2
As A plc is ungeared then this asset beta is the appropriate beta for use in the CAPM in
order to determine the discount rate that A plc should use for a computer manufacture
project:
Required return = 5 + 1.2(12 5)
= 13.4%
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Solution 5
Using MM formula find the asset beta of the computer industry:
a =
( ) ( )

+
e
T 1 Vd Ve
Ve
+
( )
( ) ( )

+

d
T 1 Vd Ve
T 1 Vd

Ba = 4 . 1
) 67 . 0 1 ( 4
4
+

Asset beta = 1.2

In order to find the discount rate for A plc this asset beta must be converted into an equity
beta appropriate to A plc:
1.2 = Be
0.67) 1 ( 2
2
+

1.2 = 0.749 Be
Be = 1.6
Ke of A plc if in computer manufacture = 5 + 1.6 (12 5)
= 16.2%
The discount rate that A plc must use is the WACC that it would have if its Ke were 16.2%.
In the absence of any other information assume Kd is 5% (risk free rate).
Discount rate = 16.2% + 5 (1 0.33)
= 11.92%