Kanpur Investment：CAPM： theory, advantages, and disadvantages

The CAPM has several advantages over other methods of calculating required return, explaining why it has been popular for more than 40 years:

It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.

It is a theoretically-derived relationship between required return and systematic risk which has been subject to frequent empirical research and testing.Kanpur Investment

It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly considers a company’s level of systematic risk relative to the stock market as a whole.

It is clearly superior to the WACC in providing discount rates for use in investment appraisal.

The CAPM suffers from several disadvantages and limitations that should be noted in a balanced discussion of this important theoretical model.

Assigning values to CAPM variables

To use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta.

The yield on short-term government debt, which is used as a substitute for the risk-free rate of return, is not fixed but changes regularly with changing economic circumstances. A short-term average value can be used to smooth out this volatility.

Finding a value for the equity risk premium (ERP) is more difficult. The return on a stock market is the sum of the average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP is not stable over time. In the UK, an ERP value of between 3.5% and 4.8% is currently seen as reasonable. However, uncertainty about the ERP value introduces uncertainty into the calculated value for the required return.

Beta values are now calculated and published regularly for all stock exchange-listed companies. The problem here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time.

Using the CAPM in investment appraisal

Problems can arise in using the CAPM to calculate a project-specific discount rateUdabur Investment. For example, one common difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The proxy beta for a proposed investment project must be disentangled from the company’s equity beta. One way to do this is to treat the equity beta as a portfolio beta (βp), an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity.

βp = (W1β1) + (W2β2)

W1 and W2 are the market value weightings of each business area

β1 and β2 are the equity betas of each business area.

Example

A proxy company, Gib Co, has an equity beta of 1.2. Approximately 75% of the business operations of Gib Co by market value are in the same business area as a proposed investment. However, 25% of its business operations by market value are in a business area unrelated to the proposed investmentChennai Investment. These unrelated business operations are 50% riskier, in systematic risk terms, than those of the proposed investment. What is proxy equity beta for the proposed investment?

Solution

Using the portfolio beta formula, βp = (W1β1) + (W2β2):

1.2 = (0.75 x β1) + (0.25 x 1.5 x β1) = (0.75 x β1) + (0.375 x β1) = 1.125 x β1

Proxy equity beta = β1 = 1.2/ 1.125 = 1.067

In this case note that β2 = 1.5 x β1

The information about relative shares of proxy company market value may be quite difficult to obtain.

A similar difficulty is that ungearing proxy company betas uses capital structure information that may not be readily available. Some companies have complex capital structures with many different sources of finance. Other companies may have untraded debt or use complex sources of finance such as convertible bonds.

The simplifying assumption that the beta of debt is zero will also lead to inaccuracy, however small, in the calculated value of the project-specific discount rate.Ahmedabad Investment

Another disadvantage in using the CAPM in investment appraisal is that the assumption of a single-period time horizon is at odds with the multi-period nature of investment appraisal. While CAPM variables can be assumed constant in successive future periods, experience indicates that this is not true in the real world.

Research has shown the CAPM stands up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, though, the CAPM remains a very useful item in the financial management toolkit.

Surat Investment