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
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).
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.
Equity capital represents money put up and owned by shareholders. This money can be used to fund projects and other opportunities under the auspice of creating greater value. This type of capital is typically the most expensive. In order to attract investors, the firms expected returns must consummate with the associated risk ("Financial leverage and,"). To illustrate this, consider a speculative oil drilling operation, this type of operation would require higher promised returns than say a Wal-Mart in order to attract investors. The two primary forms of equity capital are 1) money invested into the business for an ownership stake (i.e. stock) and 2) retained earnings from past profits used to fund future growth through acquisitions, expansions and product development.
To Markowitz, the CAPM model operates in an environment where all investors have vague assets, all investors are peril antagonistic minded, no taxes, inflation or transactions cost are added to securities purchased. Nobody likes a risky investment with a 50 percent possibility so investors look for securities with low risk and high returns. Risk free assets can be assets purchased from the government such as treasury bills and corporate bonds. In finance, the market risk is usually represented with the quantity beta (β). The beta measures the value of risk in a portfolio using the market value as a benchmark, also called the beta
In order to make a proper investment decision for her mutual fund, Miss Ford made her own discounted-cash-flow forecast. This forecast proved that Nike shares were overvalued by $5.95 per share when maintaining a discount rate of 10%. A sensitivity analysis showed that stock was undervalued at discount rates less than 9.4%. To be certain...
Corporations create two kinds of securities: bonds, representing debt, and stocks, representing ownership or equity interest in their operations. (In Great Britain, the term stock ordinarily refers to a loan, whereas the equity segment is called
The possible risks. According to James L. Davis these risks can be summarized as return predictability, financial market link to the real economy and performance persistence.
Risks are everywhere, however that does not mean one has to resort to accepting all levels of risk in the world. Risk is identifiable and as such can be mitigated down to a level where an individual is comfortable with or at the least tolerant of the risk. The stock market requires the use of an individual or business investor’s money and therefore involves considerable amounts of risk. Those who are averse to risk, yet can see the benefits of investing, must due their due diligence prior to investing in a stock that may be considered risky. By using beta and the security market line as tools to identify risk in the market, investors are able to mitigate risky decisions and build a comfortable portfolio that
Graham and Harvey surveyed the CFOs of 392 U.S. firms and found that when estimating the capital of assets,73.5% of respondents use the CAPM.( Graham, J. R., and C. R. Harvey,2001) It is a model which uses simple formula to evaluate asset pricing and investor behavior. This model is absolutely the method with most investors used, but many financial experts raise an objection to the veracity of this method in the recent years. Later in the main body of the essay will discuss these questions. In the first part of the essay will introduce the CAPM and the main factor of this method. Secondly, is the discussion of the uses and limits of the CAPM while evaluating the potential investment of a firm 's
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
Finally, Welch (2008) established from his research that 75% of finance academics recommend using the CAPM for commercial capital budgeting purposes, 10% commend the Fama French model and only 5% recommend an APT model. Therefore, Sharpe and Lintner’s CAPM is a beneficial framework.
Cost of capital refers to the cost of obtaining funds, that is, debt or equity to finance an investment project. The cost of capital is useful in assessing the applicability of a capital account because the cost of capital is the lowest return for the investor to fund the company. Different sources of capital have different capital costs. On the other hand, risk refers to the uncertainty that exists in making financial decisions. Because the forecast may be different from the actual result, for example, the stock price may change unfavorably. The risk can be divided into two categories: systemic risk and non-systemic risk. The risk is measured by variance analysis or beta. (Brigham & Ehrhardt, 2011).
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.
period of time and, in return, may receive a "bond". The bond issuer agrees to a fixed rate of
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.