Lecture03 - FIN2101 FIN2101 BUSINESS FINANCE II Module 3...

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Unformatted text preview: FIN2101 FIN2101 BUSINESS FINANCE II Module 3 Application of CAPM Student Activities Student Activities Reading • • • Text, Chapter 7 (pp. 250­1 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 CAPM SML Equation: [ k j = RF + bj × ( km - RF ) Applications of CAPM 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 CAPM As A Pricing Model • Underpriced (above SML) • Overpriced (below SML) Example ­ Overpriced Asset Example ­ Overpriced Asset DATA: D0 = $0.20 km = 11% g = 4% RF = 5% Ps = $3.90 b = 1.3 Solution ­ Step 1 Solution ­ Step 1 Expected Return (Based on Market Price): D1 ks = +g Ps $0.20 (1.04 ) = + 0.04 $3.90 = 0.093 or 9.3% Solution ­ Step 2 Solution ­ Step 2 Required Return (Based on Systematic Risk): Solution ­ Step 3 Solution ­ Step 3 Compare the expected return ks and the required rate of return kj: k s < k j, OVERPRICED Solution ­ Step 4 Solution ­ Step 4 “Correct” Price: D1 Ps = kj -g $0.20 (1.04 ) = 0.128 - 0.04 = $2.36 Example ­ Underpriced Asset Example ­ Underpriced Asset DATA: D0 = $0.20 km = 11% g = 4% RF = 5% Ps = $2.05 b = 1.3 Solution Solution ks = 0.1414 or 14.14% kj = 12.8% As ks > kj, UNDERPRICED CAPM & the Cost of Capital CAPM & the Cost of Capital CAPM is one approach for determining the required rate of return or discount rate. [ k j = RF + bj × ( km - RF ) Business vs Financial Risk 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 Business vs Financial Risk Business Risk Dj k j = R F + ( k m - R F ) b j 1 + Ej Financial Risk CAPM & Cost of Capital 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 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 CAPM Example Firm G (Book Publisher) All equity financed (unlevered) RF = 6% km = 13% bG = 1.1 kG = 13.7% Computer Software Firms Computer Software Firms Company W ⇒ b W = 1.40 k W = 15.80% Company S ⇒ bS = 1.38 k S = 15.66% Company O ⇒ b O = 1.35 k O = 15.45% All companies are entirely equity financed. Conclusion 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 Selection of a Proxy Beta Options: • • • use company’s beta choose another company’s beta use an industry average beta Proxy 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 Adjusting Beta Unless the debt­to­equity 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 Computer Software Firm B D:E Ratio of 1:2 (Levered Firm) Degearing and Regearing 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 debt­to­equity ratio. Example Data Example Data • RF = 8% • DA:EA = 1:2 • km = 14% • kdA = 13.5% • bp = 1.5 • T = 30% • Dp:Ep = 1:1 • bA = ??? Required Required Calculate the cost of capital that the firm should use to evaluate Project A. Step 1 ­ Degear Step 1 ­ Degear b UP b LP = Dp 1 + Ep Step 1 ­ Degear Step 1 ­ Degear b UP 1.5 = 1 1 + 1 1.5 = 2.0 = 0.75 Step 2 ­ Regear Step 2 ­ Regear DA b A = b UP 1 + EA Step 2 ­ Regear Step 2 ­ Regear 1 b A = 0.75 1 + 2 = 0.75 [1 + 0.5] = 1.125 Step 3 ­ Calculate Cost of Step 3 ­ Calculate Cost of Equity for Project A k A = R F + [ bA × ( k m - R F ) ] = 0.08 + [1.125 × ( 0.14 - 0.08) ] = 0.1475 or 14.75% Step 4 ­ Calculate Cost of Step 4 ­ Calculate Cost of Capital for Project A EA k = kA V A DA + k d A (1 - T ) V A 2 1 = 0.1475 + 0.135 (1 - 0.3) 3 3 = 0.0983 + 0.0315 = 0.1298 or 12.98% Other Variables in SML Other Variables in SML • Risk­free 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 risk­free rate. Advantages of CAPM Advantages of CAPM • It takes into account the risk profile of the project and arrangements. the project’s funding • It gives a cost of equity adjusted to reflect the perceived risk of the project. Efficient Market Hypothesis 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 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 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 Degrees of Efficiency • Weak Form • • Past prices cannot be used to make abnormal gains consistently. Semi­Strong Form Prices reflect all publicly available information, including past information. Strong Form Information set includes all information, both public and private. Testing of EMH Testing of EMH • Weak form ­ proved valid by testing of trading strategies. • Semi­strong 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 Conclusions on EMH • Markets appear to be efficient, at least to the semi­strong 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 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 ...
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