Capital Asset Pricing and Discounted Price Flow Models
Knowing the risk of an investment and understanding how that risk will affect any
future returns are crucial aspects in deciding if the expected return is worth the risk. The Capital Asset Pricing Model (CAPM) provides a base from which both the risk and the affects of the risk are determined by the investor while the Discounted Price Flow Model (DPCM) can help the investor decide what amount they are willing to invest in a company in anticipation of projected future cash flows.
As indicated in the previous paragraph, the Capital Asset Pricing Model is a tool used in determining the risk of an investment and in turn, deciding if the risk is worth the investment. The CAPM generally fosters the idea that not every risk is considered in determining the value of an asset; in fact, by diversification, some of the risk can be eliminated. The CAPM starts with the idea there are two primary risks involved in investments: Systematic and unsystematic.
Systematic risks are those risks, such as interest rates, that cannot be eliminated through diversification. Unsystematic risks are those risks that are inherent to specific types of stocks. As the individual investor builds his portfolio, the risks decrease. Because systemic risks are the risks that cause the most anxiety for investors and as a way to calculate those systemic risks, William Sharpe created CAPM.
With the recent spate of financial scandals, the Discounted Price Flow Model has taken on a new importance. The DPFM is used to determine a company's value based on its projected future cash flows. Forecasted free cash flows are discounted to a present value using the company's weighted average costs of capital. ...
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...ally an investment in a company's debt. It is more or less an IOU from a company with a set rate of return and the repayment of the principal at maturity. For example, if company A holds a bond for $1000 that pays 5% interest per year, they would receive 5% of $1000 every year and its $1000 back at the date of maturity. Good deal right? Wrong. Having that set rate of 5% will not generate a lot of capital that a company can use for its needs.
So, what would be most beneficial to a particular company? I would recommend stocks if short-term capital needs are the goal. Stocks, while relatively volatile, are easily liquidated and provides much more capital. I would recommend bonds only if the company's capital needs were not immediately needed. Bonds provide more stability and
REFERENCES
Investopedia
http://www.investopedia.com/articles. Retrieved April 28, 2007
He defines each of these risks, as well as gives a few examples of each one. He quickly jumps into how many tend to focus on standard deviation as the only single metric calculation, rather than recognizing there are other ways to do so. The author discourages the focus on just one risk, because all are intertwined together and rely on one another. By focusing on only one risk, for example peer risk, it leaves the company up for even more risk in its assets and pension obligations. Figure 1 illustrates that these risks do indeed rely on one another.
Earlier 2002, the stock price of Agnico-Eagle Mines sharply decreased by $1 finally closed at $13.89. This price has reached one of the lowest level, from the company's historical perspective. As a professional equity portfolio manager, who has a large number of AEM stocks on hand. Acker and his team are necessary to find a proper way to estimated the fair value of AEM as well as its equity. Discounted Cash Flow (DCF) has been chosen to do this job. The theory behind DCF valuation approach is that the firm's value can be estimated by using the expected future free cash flow discounted by an appropriate discounted rate (Koller etc 2005). However several assumptions need to be clearly examined within this approach. The following sections are showing the process of DCF step by step.
The estimates of cost of capital for equity 6.14% are making by using the capital asset pricing model (CAPM) to generate forecast of DDM and RIM. This method is defined by the sum of risk free rate plus beta that multiplied with a risk premium. Particularly, the beta, which is a quantitative measure of the volatility of company stock relative to the unstable of the overall market, found in JB HI-FI case at 0.56 (JB HI-FI financial statement 2016). It
Discounted Cash Flow Method takes the forecast free cash flows during forecasted horizon. Then we estimate the cost of capital (weighted average cost of capital) and estimate continuing value (value after forecast horizon). The future value is discounted to the present value. We than add back cash ($13 Million) and non-current assets and deduct total debt. With the information provided several assumptions had to be made to obtain reasonable values (life period of 30-years, Capital expenditures not to exceed $1 million dollars, depreciation to stay constant at $1.15 Million and a discounted rate of 10%). Based on our analysis, the company has a stand-alone value of $51 Million at the end of fiscal year end 1990 with a net present value of cash flows of $33 million that does not include the cash and non-current assets a cash of and non-current assets.
Discounted cash flow is a valuation technique that discounts projected cash inflows and outflows to evaluate the potential value of an investment. There are three discounted cash flow methods: Net Present Value (NPV), Profitability Index (PI) and Internal Rate of Return (IRR). The net present value discounts all cash inflows and outflows at a minimum rate of return, which is usually the cost of capital. The profitability index refers to the ratio of the present value of cash inflow to the present value of cash outflows. The internal rate of return refers to the interest rate that discounts cash inflow projections to the present to ensure that the present value of cash inflows is equivalent to the present value of cash outflows (Brown, 1992).
The Discounted Cash Flow Method, (DCF) summarizes a company cash flow to reflect the time value of money. It can be used to evaluate or compare investments or purchases. Unlike CAPM, DCF uses the present value concept. It puts forth the idea that money invested today should be worth more than money received in the future. Thus, the value of money received in the future is discounted to reflect its lesser value.
Ross, S.A., Westerfield, R.W., Jaffe, J. and Jordan, B.D., 2008. Modern Financial Management: International Student Edition. 8th Edition. New York: McGraw-Hill Companies.
In your response, build upon extant portfolio theory and make sure to talk about different types of risks that investors might face and how they go about managing such risks. This means you need to consider topics such as efficient frontier and optimal portfolios; as well their relevance to investment theory. Furthermore, given the nature of the assignment, avoid bringing the brokerage industry into your discussion. In other words, assume you can invest directly in the stock market and do not need any financial intermediaries like brokerage houses.
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
Capital Asset Pricing Model (CAPM) is an ex ante concept, which is built on the portfolio theory established by Markowitz (Bhatnagar and Ramlogan 2012). It enhances the understanding of elements of asset prices, specifically the linear relationship between risk and expected return (Perold 2004). The direct correlation between risk and return is well defined by the security market line (SML), where market risk of an asset is associated with the return and risk of the market along with the risk free rate to estimate expected return on an asset (Watson and Head 1998 cited in Laubscher 2002).
According to Investopedia (Asset Allocation Definition, 2013), asset allocation is an investment strategy that aims to balance risk and reward by distributing a portfolio’s assets according to an individual’s goals, risk tolerance and investment horizon. There are three main asset classes: equities, fixed-income, cash and cash equivalents; but they all have different levels of risk and return. A prudent investor should be careful in allocating each asset class to his portfolio. Proper asset allocation is a highly debatable subject and is not designed equally for everybody, but is rather based on the desires and needs of the individual investor. This paper discusses the importance of asset allocation, the differences and the proper diversification within the portfolio.
Bond is a kind of financial contract, which is issued by the government, financial institutions, industrial and commercial enterprises directly to the society to borrow money, issued to the investors, at the same time promised to pay interest at a certain rate and repay the principal according to the agreed conditions. On the other side, a stock is a security issued by a stock company for the purpose of raising funds
The beta is the relevant measure of risk. Formulas that show a stock with high standard deviation will have a high beta which shows that the stock has a high risk (p.257). Sharpe (2016), states that the CAPM model is only valid with the following assumptions: (1) investors are risk adverse individuals who wish to maximize their investment; (2) investors have similar expectations about asset returns and everyone has the same information at the same time; (3) assets are distributed by normal distribution; (4) investors can borrow or lend assets at a constant rate; (5) a definite number of assets and quantities are fixed in one period; (6) assets are divisible and priced in a competitive market; (7) asset markets are frictionless information and is costless and available to all investors; (8) there are no market imperfections such as taxes or regulations. The formula used is expected security returns=riskless returns + beta X (expected market risk premium) r=RF+Beta x (RM-RF)
Compared to banks and lenders, investors putting up equity tend to take a more long-term view and most don't expect a return on their investment immediately. None of the profits will need to be channeled into loan repayment, and more cash on hand will be available for expanding the business, in addition to there being no requirement to pay back the investment if the operation or project fails. On the other hand, a bank or lending institution has no say in the way you run your company and does not have any ownership in the business, and the business relationship ends once the debt is repaid. Interest on the loan is tax deductible, and principal and interest are figures you can plan on in a budget (provided that you don't take a variable rate loan). Ultimately, the best combination of equity and debt financing will depend on the business needs and what is the best fit for the project.
The Modern portfolio theory {MPT}, "proposes how rational investors will use diversification to optimize their portfolios, and how an asset should be priced given its risk relative to the market as a whole. The basic concepts of the theory are the efficient frontier, Capital Asset Pricing Model and beta coefficient, the Capital Market Line and the Securities Market Line. MPT models the return of an asset as a random variable and a portfolio as a weighted combination of assets; the return of a portfolio is thus also a random variable and consequently has an expected value and a variance.