Capital Asset Pricing Model - Case Study Example

Finance: Capital Asset Pricing Model Student’s Name Course Professor’s Name University City (Sate) Date Introduction The concept of risk and returns was not fundamental until the later 1960s when the first Capital Asset Pricing Model was developed. Measuring risk is an imperative practice especially for investors whose returns are coupled with economic and business uncertainties. To create investors’ confidence, the incorporation of risks in the computation of risk-adjusted returns has been the major focus for companies. Therefore, entities have invested efforts hugely in managing their internal operations to ensure that they report positive cash flows by mitigating or minimizing business risks. Importantly, the rising concerns on business risks is due to the fact that they are firm-specific unlike unsystematic risks. That said, empirical evidences regarding the validity and the usefulness of CAPM are more compelling than those that dwell on its limitations. Historical Account of CAPM The CAPM was first developed by Jack Treynor, who was a student at Haverford College in the early 1950s (Sullivan, 2006: Perold, 2004). The genesis of the evolution of the CAPM and the calculation of returns and risks using quite sophisticated methods began in the early 1950s when Harry Markowitz found the theory of investor preference. His empirical proposition in the theory was that the investors had the choice to make the decision of combining stocks-what is now referred to us the portfolio. Harry believed that investors could establish a portfolio so as to trade-off the risks and the returns. At this time, the portfolio risk and returns were computed to influence the investor’s decision. Furthermore, in retrospect, the determination of the cost of an asset was assumed to largely dependent on the methodology used to value that asset and not the payout policies as seconded by Miller and Modigiliani (DeAngelo and DeAngelo, 2006, 293). When the technology advanced and the researchers were now able to collect and process data efficiently, William Sharpe, Jack Treynor, John Lintner and Jan Mossin developed further the CAPM in 1960. Modern finance featured the determination of the cost of capital based on the amount of finance that a company has. This approach has received various criticism on the argument that the valuation of asset cannot only be based on the amount that was used to finance the asset. The approach that Modiglian and Miller used concerning the valuation of business or calculation of the weighted cost of capital has been considered subjective since it hugely depends on the forecast of returns (Perold, 2004, 5). With the nature of the economic situation and markets that faces different countries, then forecasting the cash flows and using it to calculate the expected returns was not attractive to investors. The CAPM was developed to facilitate the understanding of the relationship between risk and returns. While economists Miller and Modigliani believed that the dividend policy was irrelevant when making investment decisions, Lintner believed that the financial policy of a company was very imperative in the determination of returns. The CAPM was backed up by the likes of William Sharpe, Lintner and Mossin who have been credited for their contributions in the finance. Nonetheless, Jack came to be recognized in the recent generation since his failure to publish his work during those time made other contributors more famous. The Critique of CAPM The most interesting part of the CAPM is that it takes into account the systematic risks. It requires one to understand the distinct features of the two categories of risks and know which one is usually considered by business during the computation of the rate of returns. The systematic and unsystematic risks both play a significant role and in fact, they make the model to be more reliable than other models such as the dividend discount model. It is worth to discern that the systematic represents the overall market dynamics that have influence on the rate of returns. While it remains uncontrollable, the CAPM includes the systematic risk as the market risk and is in turn used to arrive at the market premium. Therefore, the investor is contended that the market premium both systematic and unsystematic risks are accounted for in the model. However, an empirical investigation by Galagedera, 2007, 14) revealed that the inclusion of systematic risks did not influence the returns hugely as it was for the case of normality of returns. In fact, the author proposes that the CAPM can hold if beta only is priced and returns are normalized. The CAPM is flexible since it can be applied during the variability of financial and business risks. The other models such as the Weighted Average Cost of Capital approach may be very difficult to adjust when the cash flow of a business is more volatile from period to period. Notably, the WACC is usually computed based on the average of the cost of equity and debt. The investment decision by the management relies upon an objective discounting factor, which it can suitably be determined by the CAPM (Uhman and Nepovolný, p.1). The reason is that the model incorporates the risks unlike the WACC. Some researchers have criticized the CAPM model by pointing out a few of its limitations. According to Dempsey (2013, 7) applying the CAPM model is a way of encountering the market based on our own terms rather than the market’s. The model seeks to reflect the market as a rational one which in reality it contradicts empirical evidences (Dempsey, 2013, 23). Since the market cannot be rational or perfect, the risk-free return will always change especially if the asset’s price is more volatile. The CAPM model provides foru decision criteria as artciultated by Magni (2010, 7). The equilibrium net present value and the disequilibrium net future value are the two criteria among the four that Magni say they are not reliable for decision and valuation purposes (p.7). Nonetheless, the CAPM is believed to have paved way for more sophisticated models that are a result of the refinement process. It has proved to even hold in emerging markets such as the Central and South-East European markets. Therefore, even though the model works based on certain assumptions, it has become the basis for valuation of businesses and investment decisions. Overall, the determination of the discounting factor for business can take various approaches. The WACC has been widely used but the modern financiers are using the CAPM. The concept of including the systemic risk factor in the model has been quite contributively in the development of investment and valuation issues. Future Developments and Possible Evolvement One of the future possible developments is the inclusion of scientific models in the determination of discounting factors. Dempsey (2013, 23) points out that the CAPM has a limitation of making its users to understand the market on their own terms. He articulates that the incorporation of risk-free return is imputed and that it does not change (Brown and Walter, 2013, 44). In reality, he adds, if the market is left without the CAPM the returns will react to the nature of the information in the market either negatively or passively. For instance, if the market information contains good news then the returns will respond positively and vice vasa. Therefore, the development that future research will incorporate is the addition of scientific models so as to obtain more realistic results. Such a model will seek not to make the managers and investors to understand the market in their own terms but in the market’s. The second possible development is advancement of the Behavioural Asset Pricing (BAP) model. The recent research recommendations are centring through market conditions and nature of risks. Raei, Ahmadinia and Hasbaei (2011, 147) assert that choosing a CAPM requires one to forecast effectively all the variables that affect the validity of the model. In addition, there is a need for investors to have a perfect knowledge of the market’s financial condition. The developing model that is derived from the concept of CAPM is the BAP model. This approach is in its developing stage and is expected to replace the CAPM in the future. The BAP model takes into account the behavioural aspects of the risks and returns in the determination of the discounting factor. Hence, it may be the new model that will address the drawbacks put forth by the CAPM model. Conclusion The concept of risk and returns and their relationship has been studied for a very long period. The CAPM was first developed by Jackson Treynor and later developed further by renowned economists, such as William Sharpe, John Lintner and John Mossin in the 1960s. The CAPM was used to determine the rate of return by including the systematic risk in the model. The investors were able to benefit from risk-free return as the asset returns were determined by the level of market risk. Despite being a very useful model for many years, recent studies are considering shifting to new models that are perceived as more realistic. For instance, realistically, the risk-free return does not remain constant since the returns adjust depending on the market performance. It is for this reason that we expected future developments in the CAPM to be more scientific or even advance the model to include behavioural aspects of the risks and returns. Reference List Sullivan, E.J., 2006. A Brief History of the Capital Asset Pricing Model. Association of Pennsylvania University Business and Economic Faculties. Perold, A.F., 2004. The capital asset pricing model. The Journal of Economic Perspectives, 18(3), pp.3-24. DeAngelo, H. and DeAngelo, L., 2006. The irrelevance of the MM dividend irrelevance theorem. Journal of financial economics, 79(2), pp.293-315. Galagedera, D.U., 2007. A review of capital asset pricing models. Managerial Finance, 33(10), pp.821-832. Uhman, J. and Nepovolný, T., The problem of determining the WACC. http://uhman.cz/wp-content/uploads/2014/08/The-problem-of-determining-the-WACC.pdf Dempsey, M., 2013. The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus, 49(S1), pp.7-23. Brown, P. and Walter, T., 2013. The CAPM: theoretical validity, empirical intractability and practical applications. Abacus, 49(S1), pp.44-50. Raei, R., Ahmadinia, H. and Hasbaei, A., 2011. A Study on Developing of Asset Pricing Models. Journal of Accounting and Finance, 1(1), p.1. Magni, C.A., 2010. CAPM and capital budgeting: present/future, equilibrium/disequilibrium, decision/valuation. IUP Journal of Financial Economics, 8(1/2), p.7. Read More