CORPORATE FINANCE

Corporate Finance



Corporate Finance

Question 2

In calculating CAPM, the information below was needed. We have decided to calculate CAPM and WACC for the last 3 years; 2009-2011. This was done in order to have a better and more accurate analysis by incorporating information for the last 3 years and taking the average, to be able to eliminate any outliers or abnormal activities within the last 3 financial/economic year's e.g. 2009 financial crisis, petrol price rises etc.

For CAPM

The Capital Asset Pricing Model is selected to compute the cost of capital. The UK bench mark yield to maturity on a Ten Years bond for past 3 years is used as a proxy for the Risk Free Rate. The FTSE 100 is used as a proxy for the expected return for the market and it was obtained by computing the historical average of the historical annual returns on that price index over the past 3 years. Using the CAPM formulae: E (Ri) = Rf + ßi (E(Rm) - Rf)

Where,

E (ri) is the expected rate of return of capital on the asset i.

ßim is the Beta (amount of risk with respect to the Market Portfolio)

E (rm - rf) is the excess return of the market portfolio.

(rm) Performance of the market.

(rf) Return on risk free asset.

Average risk free rate = (3.33 + 3.55 + 3.07/3) = 3.33%

Year

Average annual %

2009

3.33

2010

3.55

2011

3.07

Average Beta = (1.62 + 1.52 + 1.47) = 1.53

Year

beta

2009

1.62

2010

1.52

2011

1.47

3-Year Average market return for FTSE 100 = 5.83

Year

return

2009

4.6

2010

7.1

2011

5.8

Therefore our cost of equity using CAPM is:

= 3.33 +1.53 (5.83-3.33) = 7.155%

Capital Asset Pricing Model

The CAPM is a financing model used to assess the value of market portfolios by examining the relating systemic risk and the expected return. In actuality, the theory divides risk into two categories of risk, systemic and specific. Although, the CAPM only compensates investors for the systemic risk of the holding a portfolio since specific risk can be diversified. Risk in the CAPM is assumed as wanting to be avoided, but if the risk is accepted then investors expect to be rewarded, called risk premium. In addition to the risk premium paid to the investor, he or she will also be rewarded the risk-free return rate.

Beta Analysis

It is important to emphasize the importance of Beta (which is measured along the horizontal axis). Beta is the risk, and undiversifiable risk depends on the market. If the beta is zero, the expected return is only Rf, the value of risk-free asset, which would be its minimum value: for example, the value of Treasury Bonds U.S. As the Beta begins to increase (rightward shift of the horizontal curve) also increases the expected return. When beta is equal to 1, our expected return will equal the market return (Marsh, 2008, 77-80). This is the reason why a high Beta tends to amplify the response of the system. If the Beta is 2, the portfolio return will increase much faster if the market goes up, for example, 10%, but also fall faster if the market ...