FIN2101
BUSINESS FINANCE II
Module 3
Application of CAPM
Student Activities
Reading
Text,Chapter 7 (pp,250-1 only)
Text Study Guide,Chapter 7 (part only)
Study Book,Module 3 (inc,Appendix 3.1)
Tutorial Work
Tutorial Workbook,Self Assessment Activity 3.1
Text Study Guide,Chapter 7,T/F 7,MC 12,13
CAPM
SML Equation:
R - k b + R = k FmjFj?
Applications of CAPM
As a pricing model – compare the required
return from CAPM with the anticipated or
expected return based on market prices.
To calculate the cost of capital for a
company,a division of a company,or
even a specific project.
CAPM As A Pricing Model
Underpriced (above SML)
Overpriced (below SML)
Example - Overpriced Asset
DATA:
D0 = $0.20 km = 11%
g = 4% RF = 5%
Ps = $3.90 b = 1.3
Solution - Step 1
Expected Return (Based on Market Price):
9.3 %or 0.0 93
0.0 4
$3,90
1.0 4 $0,20
g
P
D
k
s
1
s
Solution - Step 2
Required Return (Based on Systematic Risk):
12.8%or 0.128
0.05 - 0.11 1.3 0.05
R - k b R k
FmjFj
Solution - Step 3
Compare the expected return ks and the
required rate of return kj:
ks < kj,OVERPRICED
Solution - Step 4
“Correct” Price,
$2,36
0.0 4 - 0.1 28
1.0 4 $0,20
g - k
D
P
j
1
s
Example - Underpriced Asset
DATA:
D0 = $0.20 km = 11%
g = 4% RF = 5%
Ps = $2.05 b = 1.3
Solution
ks = 0.1414 or 14.14%
kj = 12.8%
As ks > kj,UNDERPRICED
CAPM & the Cost of Capital
CAPM is one approach for determining the
required rate of return or discount rate.
R - k b + R = k FmjFj?
Business vs Financial Risk
SML equation represents the business
risk for a company that is funded entirely
from equity sources (no debt).
kj also called the cost of equity capital.
Use of debt introduces financial risk.
Adjust beta to reflect both the company’s
business and financial risk.
Business vs Financial Risk
j
j
jFmFj
E
D
+ 1b R - k + R = k
Business Risk
Financial Risk
CAPM & Cost of Capital
Beta should reflect a company’s business
risk and financial risk,and so we can use
the CAPM to calculate the company’s cost
of equity capital which,in turn,can be
used to calculate the firm’s overall cost of
capital.
CAPM & A Project’s Cost of
Capital
In evaluating a specific project,the firm
can use its cost of equity capital and
overall cost of capital as the discount rate
provided that the business risk and
financial risk of the project are
identical to the firm’s business risk
and financial risk.
This is not always the case,particularly for
diversified firms.
CAPM Example
Firm G (Book Publisher)
All equity financed (unlevered)
RF = 6% km = 13%
bG = 1.1 kG = 13.7%
Computer Software Firms
15,4 5% = k 1,35 = b OC om pa n y
15,6 6% = k 1,38 = b SC om pa n y
15,8 0% = k 1,40 = b C om pa n y W
OO
SS
WW
All companies are entirely equity financed.
Conclusion
The book publishing industry is not as
risky as the computer software industry.
Company G’s beta as a book publisher is
irrelevant to its beta as a software
industry firm.
We need to find a proxy.
Selection of a Proxy Beta
Options:
use company’s beta
choose another company’s beta
use an industry average beta
Proxy Beta
The first step in selecting a proxy beta is
to find a company whose business risk is
similar to that of the proposed project.
In our Company G example,we could
choose one of W,S or O who are all
specialist computer software firms.
Adjusting Beta
Unless the debt-to-equity ratio of the
project matches that of the proxy,we
must degear the proxy beta and then
regear it to reflect the financial risk of our
project.
Computer Software Firm B
1 9,6 5 % = k 1,9 5 = b BB
D:E Ratio of 1:2 (Levered Firm)
Degearing and Regearing
Beta
Degearing removes the financial risk
from the proxy beta to give the
unlevered or equity beta.
Regearing adjusts the unlevered beta for
the project’s financial risk,based on the
project’s debt-to-equity ratio.
Example Data
RF = 8%
km = 14%
bp = 1.5
Dp:Ep = 1:1
DA:EA = 1:2
kdA = 13.5%
T = 30%
bA =
Required
Calculate the cost of capital that the firm
should use to evaluate Project A.
Step 1 - Degear
p
p
LP
UP
E
D
+ 1
b
= b
Step 1 - Degear
0.75
2.0
1.5
1
1
1
1.5
b
UP
Step 2 - Regear
A
A
UPA
E
D
+ 1 b = b
Step 2 - Regear
1.125
0.5 1 0.75
2
1
1 0.75 b
A
Step 3 - Calculate Cost of
Equity for Project A
14.75%or 0.1475
0.08 - 0.14 1.125 0.08
R - k b + R = k
FmAFA
Step 4 - Calculate Cost of
Capital for Project A
12,98%or 0.1 298
0.0 315 0.0 983
3
1
0.3 - 1 0.1 35
3
2
0.1 475
V
D
T - 1 k +
V
E
k =k
A
A
d
A
A
A
A
Other Variables in SML
Risk-free Rate of Return
The current yield on a government
security whose term to maturity matches
the life of the project.
Expected Return on Market Portfolio
Market risk premium plus risk-free rate.
Advantages of CAPM
It takes into account the risk profile of the
project and the project’s funding
arrangements.
It gives a cost of equity adjusted to reflect
the perceived risk of the project.
Efficient Market Hypothesis
According to CAPM,when the market is in
equilibrium,share prices reflect the true
value of a company.
However,it is the investor’s objective to
gain from holding shares,either by way of
a capital gain and/or dividend yield.
Efficient Market Hypothesis
EMH says that it is impossible to gain an
information advantage and to make
abnormal gains consistently.
An efficient market is one in which the
prices of securities,fully reflect” all
available information.
Efficient Market Hypothesis
EMH requires a highly efficient market
mechanism for trading shares.
All relevant information is absorbed both
quickly and rationally into the market price
of shares by investors so that it is virtually
impossible to consistently make abnormal
returns.
Degrees of Efficiency
Weak Form
Past prices cannot be used to make abnormal
gains consistently.
Semi-Strong Form
Prices reflect all publicly available
information,including past information.
Strong Form
Information set includes all information,both
public and private.
Testing of EMH
Weak form - proved valid by testing of
trading strategies.
Semi-strong form - tested using event
studies where the event might be a bonus
issue or a new issue of stock.
Strong form - difficult to test although
there have been some event studies done.
Conclusions on EMH
Markets appear to be efficient,at least to
the semi-strong form - don’t bother trying
to outperform the market.
Technical and fundamental analysis is a
waste of time!
Sufficient validity to retain CAPM in
attempting to understand the behaviour of
investors and the pricing of risky assets.
EMH Anomalies
Seasonal effects
–day of the week,eg low returns
Tuesday,high returns Thursday; public
holidays
–month of the year,eg January effect
Size of the firm (small firms’ returns too
high)
Around particular events,eg takeovers
BUSINESS FINANCE II
Module 3
Application of CAPM
Student Activities
Reading
Text,Chapter 7 (pp,250-1 only)
Text Study Guide,Chapter 7 (part only)
Study Book,Module 3 (inc,Appendix 3.1)
Tutorial Work
Tutorial Workbook,Self Assessment Activity 3.1
Text Study Guide,Chapter 7,T/F 7,MC 12,13
CAPM
SML Equation:
R - k b + R = k FmjFj?
Applications of CAPM
As a pricing model – compare the required
return from CAPM with the anticipated or
expected return based on market prices.
To calculate the cost of capital for a
company,a division of a company,or
even a specific project.
CAPM As A Pricing Model
Underpriced (above SML)
Overpriced (below SML)
Example - Overpriced Asset
DATA:
D0 = $0.20 km = 11%
g = 4% RF = 5%
Ps = $3.90 b = 1.3
Solution - Step 1
Expected Return (Based on Market Price):
9.3 %or 0.0 93
0.0 4
$3,90
1.0 4 $0,20
g
P
D
k
s
1
s
Solution - Step 2
Required Return (Based on Systematic Risk):
12.8%or 0.128
0.05 - 0.11 1.3 0.05
R - k b R k
FmjFj
Solution - Step 3
Compare the expected return ks and the
required rate of return kj:
ks < kj,OVERPRICED
Solution - Step 4
“Correct” Price,
$2,36
0.0 4 - 0.1 28
1.0 4 $0,20
g - k
D
P
j
1
s
Example - Underpriced Asset
DATA:
D0 = $0.20 km = 11%
g = 4% RF = 5%
Ps = $2.05 b = 1.3
Solution
ks = 0.1414 or 14.14%
kj = 12.8%
As ks > kj,UNDERPRICED
CAPM & the Cost of Capital
CAPM is one approach for determining the
required rate of return or discount rate.
R - k b + R = k FmjFj?
Business vs Financial Risk
SML equation represents the business
risk for a company that is funded entirely
from equity sources (no debt).
kj also called the cost of equity capital.
Use of debt introduces financial risk.
Adjust beta to reflect both the company’s
business and financial risk.
Business vs Financial Risk
j
j
jFmFj
E
D
+ 1b R - k + R = k
Business Risk
Financial Risk
CAPM & Cost of Capital
Beta should reflect a company’s business
risk and financial risk,and so we can use
the CAPM to calculate the company’s cost
of equity capital which,in turn,can be
used to calculate the firm’s overall cost of
capital.
CAPM & A Project’s Cost of
Capital
In evaluating a specific project,the firm
can use its cost of equity capital and
overall cost of capital as the discount rate
provided that the business risk and
financial risk of the project are
identical to the firm’s business risk
and financial risk.
This is not always the case,particularly for
diversified firms.
CAPM Example
Firm G (Book Publisher)
All equity financed (unlevered)
RF = 6% km = 13%
bG = 1.1 kG = 13.7%
Computer Software Firms
15,4 5% = k 1,35 = b OC om pa n y
15,6 6% = k 1,38 = b SC om pa n y
15,8 0% = k 1,40 = b C om pa n y W
OO
SS
WW
All companies are entirely equity financed.
Conclusion
The book publishing industry is not as
risky as the computer software industry.
Company G’s beta as a book publisher is
irrelevant to its beta as a software
industry firm.
We need to find a proxy.
Selection of a Proxy Beta
Options:
use company’s beta
choose another company’s beta
use an industry average beta
Proxy Beta
The first step in selecting a proxy beta is
to find a company whose business risk is
similar to that of the proposed project.
In our Company G example,we could
choose one of W,S or O who are all
specialist computer software firms.
Adjusting Beta
Unless the debt-to-equity ratio of the
project matches that of the proxy,we
must degear the proxy beta and then
regear it to reflect the financial risk of our
project.
Computer Software Firm B
1 9,6 5 % = k 1,9 5 = b BB
D:E Ratio of 1:2 (Levered Firm)
Degearing and Regearing
Beta
Degearing removes the financial risk
from the proxy beta to give the
unlevered or equity beta.
Regearing adjusts the unlevered beta for
the project’s financial risk,based on the
project’s debt-to-equity ratio.
Example Data
RF = 8%
km = 14%
bp = 1.5
Dp:Ep = 1:1
DA:EA = 1:2
kdA = 13.5%
T = 30%
bA =
Required
Calculate the cost of capital that the firm
should use to evaluate Project A.
Step 1 - Degear
p
p
LP
UP
E
D
+ 1
b
= b
Step 1 - Degear
0.75
2.0
1.5
1
1
1
1.5
b
UP
Step 2 - Regear
A
A
UPA
E
D
+ 1 b = b
Step 2 - Regear
1.125
0.5 1 0.75
2
1
1 0.75 b
A
Step 3 - Calculate Cost of
Equity for Project A
14.75%or 0.1475
0.08 - 0.14 1.125 0.08
R - k b + R = k
FmAFA
Step 4 - Calculate Cost of
Capital for Project A
12,98%or 0.1 298
0.0 315 0.0 983
3
1
0.3 - 1 0.1 35
3
2
0.1 475
V
D
T - 1 k +
V
E
k =k
A
A
d
A
A
A
A
Other Variables in SML
Risk-free Rate of Return
The current yield on a government
security whose term to maturity matches
the life of the project.
Expected Return on Market Portfolio
Market risk premium plus risk-free rate.
Advantages of CAPM
It takes into account the risk profile of the
project and the project’s funding
arrangements.
It gives a cost of equity adjusted to reflect
the perceived risk of the project.
Efficient Market Hypothesis
According to CAPM,when the market is in
equilibrium,share prices reflect the true
value of a company.
However,it is the investor’s objective to
gain from holding shares,either by way of
a capital gain and/or dividend yield.
Efficient Market Hypothesis
EMH says that it is impossible to gain an
information advantage and to make
abnormal gains consistently.
An efficient market is one in which the
prices of securities,fully reflect” all
available information.
Efficient Market Hypothesis
EMH requires a highly efficient market
mechanism for trading shares.
All relevant information is absorbed both
quickly and rationally into the market price
of shares by investors so that it is virtually
impossible to consistently make abnormal
returns.
Degrees of Efficiency
Weak Form
Past prices cannot be used to make abnormal
gains consistently.
Semi-Strong Form
Prices reflect all publicly available
information,including past information.
Strong Form
Information set includes all information,both
public and private.
Testing of EMH
Weak form - proved valid by testing of
trading strategies.
Semi-strong form - tested using event
studies where the event might be a bonus
issue or a new issue of stock.
Strong form - difficult to test although
there have been some event studies done.
Conclusions on EMH
Markets appear to be efficient,at least to
the semi-strong form - don’t bother trying
to outperform the market.
Technical and fundamental analysis is a
waste of time!
Sufficient validity to retain CAPM in
attempting to understand the behaviour of
investors and the pricing of risky assets.
EMH Anomalies
Seasonal effects
–day of the week,eg low returns
Tuesday,high returns Thursday; public
holidays
–month of the year,eg January effect
Size of the firm (small firms’ returns too
high)
Around particular events,eg takeovers
