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capm ACCA F9

capm ACCA F9

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Published by Kalyan Adhikari
capm f9 acca
cost of capital
capm f9 acca
cost of capital

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Published by: Kalyan Adhikari on May 24, 2013
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technical
page 50
student accountant
JUNe/JULY 2008
CAPM: THEORY,ADVANTAGES, ANDDISADVANTAGES
THE CAPITAL ASSET PRICING MODELRELEVANT TO ACCA QUALIFICATION PAPER F9
CAPM FORMULA
The linear relationship between the returnrequired on an investment (whether in stockmarket securities or in business operations)and its systematic risk is represented by theCAPM formula, which is given in the Paper F9Formulae Sheet:E(ri) = Rf+
β
i(E(rm) - Rf)E(ri) = return required on financial asset iRf= risk-free rate of return
β
i= beta value for financial asset iE(rm) = average return on the capital marketThe CAPM is an important area of financialmanagement. In fact, it has even been suggestedthat finance only became ‘a fully-fledged, scientificdiscipline’ when William Sharpe published hisderivation of the CAPM in 1986
1
.
CAPM ASSUMPTIONS
The CAPM is often criticised as being unrealisticbecause of the assumptions on which it is based,so it is important to be aware of these assumptionsand the reasons why they are criticised. Theassumptions are as follows
2
:
Investors hold diversified portfolios
This assumption means that investors will onlyrequire a return for the systematic risk of theirportfolios, since unsystematic risk has beenremoved and can be ignored.
Single-period transaction horizon
A standardised holding period is assumed by theCAPM in order to make comparable the returns ondifferent securities. A return over six months, forexample, cannot be compared to a return over 12months. A holding period of one year is usually used.
Investors can borrow and lend at the risk-free rateof return
This is an assumption made by portfolio theory,from which the CAPM was developed, and providesa minimum level of return required by investors.The risk-free rate of return corresponds to theintersection of the security market line (SML) andthe y-axis (see
Figure 1
). The SML is a graphicalrepresentation of the CAPM formula.
Perfect capital market
This assumption means that all securities arevalued correctly and that their returns will plot onto the SML. A perfect capital market requires thefollowing: that there are no taxes or transactioncosts; that perfect information is freely availableto all investors who, as a result, have the sameexpectations; that all investors are risk averse,rational and desire to maximise their own utility;and that there are a large number of buyers andsellers in the market.
FIGURE 1: THE SECURITY MARKET LINE
 While the assumptions made by the CAPM allowit to focus on the relationship between returnand systematic risk, the idealised world createdby the assumptions is not the same as the realworld in which investment decisions are made bycompanies and individuals.
Section F of the
Study Guide
for Paper F9 contains several references to the capital asset pricingmodel (CAPM). This article is the last in a series of three, and looks at the theory, advantages,and disadvantages of the CAPM. The first article, published in the January 2008 issue of
 student accountant
introduced the CAPM and its components, showed how the model can be used toestimate the cost of equity, and introduced the asset beta formula. The second article, published inthe April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to usein investment appraisal.
ReturnE(ri)RmRfSML1
β
 
technical
page 51
This investment decision is also incorrect,however, since project B would be rejected ifusing a CAPM-derived project-specific discountrate, because the project IRR offers insufficientcompensation for its level of systematic risk
4
.
FIGURE 2: WACC OR CAPM?
 
ADVANTAGES OF THE CAPM
The CAPM has several advantages over othermethods of calculating required return, explainingwhy it has remained popular for more than 40 years:It considers only systematic risk, reflecting areality in which most investors have diversifiedportfolios from which unsystematic risk hasbeen essentially eliminated.For example, real-world capital markets areclearly not perfect. Even though it can be arguedthat well-developed stock markets do, in practice,exhibit a high degree of efficiency, there is scopefor stock market securities to be priced incorrectlyand, as a result, for their returns not to plot on tothe SML.The assumption of a single-period transactionhorizon appears reasonable from a real-worldperspective, because even though many investorshold securities for much longer than one year,returns on securities are usually quoted on anannual basis.The assumption that investors hold diversifiedportfolios means that all investors want to hold aportfolio that reflects the stock market as a whole.Although it is not possible to own the marketportfolio itself, it is quite easy and inexpensivefor investors to diversify away specific orunsystematic risk and to construct portfolios that‘track’ the stock market. Assuming that investorsare concerned only with receiving financialcompensation for systematic risk seems thereforeto be quite reasonable.A more serious problem is that, in reality,it is not possible for investors to borrow at therisk-free rate (for which the yield on short-datedGovernment debt is taken as a proxy). The reasonfor this is that the risk associated with individualinvestors is much higher than that associated withthe Government. This inability to borrow at therisk-free rate means that the slope of the SML isshallower in practice than in theory.Overall, it seems reasonable to conclude thatwhile the assumptions of the CAPM representan idealised rather than real-world view, thereis a strong possibility, in reality, of a linearrelationship existing between required return andsystematic risk.
WACC AND CAPM
The weighted average cost of capital (WACC)can be used as the discount rate in investmentappraisal provided that a number of restrictiveassumptions are met. These assumptionsare that:the investment project is small compared tothe investing organisationthe business activities of the investmentproject are similar to the business activitiescurrently undertaken by the investingorganisationthe financing mix used to undertake theinvestment project is similar to the currentfinancing mix (or capital structure) of theinvesting companyexisting finance providers of the investingcompany do not change their required ratesof return as a result of the investment projectbeing undertaken.These assumptions essentially state that WACCcan be used as the discount rate provided thatthe investment project does not change eitherthe business risk or the financial risk of theinvesting organisation.If the business risk of the investment project isdifferent to that of the investing organisation, theCAPM can be used to calculate a project-specificdiscount rate. The procedure for this calculationwas covered in the second article in this series
3
.The benefit of using a CAPM-derivedproject-specific discount rate is illustrated in
Figure 2
. Using the CAPM will lead to betterinvestment decisions than using the WACC in thetwo shaded areas, which can be represented byprojects A and B.Project A would be rejected if WACC was usedas the discount rate, because the internal rateof return (IRR) of the project is less than that ofthe WACC. This investment decision is incorrect,however, since project A would be accepted ifa CAPM-derived project-specific discount ratewere used because the project IRR lies above theSML. The project offers a return greater than thatneeded to compensate for its level of systematicrisk, and accepting it will increase the wealthof shareholders.Project B would be accepted if WACC wasused as the discount rate because its IRR isgreater than the WACC.CRf0SMLWACC
β
Company
β
AxBx
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D
linked performance objectives
performaNce obJectives 15 aNd 16 are reLevaNt to paper f9

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