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Strength and weakness of CAPM
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Introduction
Long-term financing strategies help ensure that the money invested today will earn more than or equal to the amount invested. The capital asset pricing model (CAPM) and discounted cash flow method (DCF) will be compared. The debt and equity mix help a company optimize its wealth. The debt and equity mix will be examined along with characteristics of the financial market, and debt and equity instruments. Finally, long-term finance alternatives such as stocks, bonds, and leases are discussed.
Capital asset pricing model vs. discounted cash flow method
Two methods can be used to calculate the required return on common stock. The first method is capital asset pricing model, or CAPM. In CAPM, the required return on common stock is reached by adding the risk-free rate of return to historical validity of the return. The historical validity of the return is calculated by subtracting the return in the market from the risk-free rate of return.
The discounted cash flow method, or DCF, "uses future free cash flow projections and discounts them (most often using the weighted average cost of capital) to arrive at a present value, which is used to evaluate the potential for investment," (Investopedia, 2007). A good opportunity exists when the potential for investment is greater than the current cost. The DCF method is used to account for the time value of money, this means the value of a dollar today has a lesser value in the future, all else being equal. The following chart shows how the two methods are calculated and what drawbacks may exist.
Description Formula Drawbacks
Capital Asset Pricing Model (CAPM) "CAPM relates the risk-return trade-offs of individual assets to market returns," (Block & Hirt, 2005). Kj = + Km + e
Kj = Return on individual common stock of a company
= Alpha, the intercept on the y-axis
= Beta, the coefficient
Km = Return on the stock market (an index of stock returns is used, usually the Standard & Poor's 500 Index)
e = Error term of the regression equation
CAPM does not measure all types of assets easily.
Discounted Cash Flow Method (DCF) DCF uses future cash flow and discounts it to get the present value. CF1 CF2 CFn
DCF = -------- + -------- +
------
(1 + r)1 (1 + r)2 (1 + r)n
Star Appliance is looking to expand their product line and is considering three different projects: dishwashers, garbage disposals, and trash compactors. We want to determine which project would be worth doing by determining if they will add value to Star. Thus, the project(s) that will add the most value to Star Appliance will be worth pursuing. The current hurdle rate of 10% should be re-evaluated by finding the weighted average cost of capital (WACC). Then by forecasting the cash flows of each project and discounting them by the WACC to find the net present value, or by solving for the internal rate of return, we should be able to see which projects Star should undertake.
The first important component of DCF needs to be estimated is the expected future Free cash flow of the company. However FCF prediction has already been done by Acker. The relevant data is the estimated cash flow from 2002 to 2008, As well as the real FCF at the end of 2001. all figures in this report is in $ value:
We defined several criteria to determine our choice – return, risks and other quantitative and qualitative factors. Targeting a debt ratio of 40% will maximize the firm’s value. A higher earning’s per share and dividends per share will lead to a higher stock price in the future. Due to leveraging, return on equity is higher because debt is the major source of financing capital expenditures. To maintain the 40% debt ratio, no equity issues will be declared until 1985. DuPont will be financing the needed funds by debt. For 1986 onwards, minimum equity funds will be issued. It will be timed to take advantage of favorable market condition. The rest of the financing required will be acquired by issuing debt.
This object is one of the financial goals to invest properly. Marriott used discounted cash flow techniques to evaluate potential investment. It is beneficial because it is considered present time value. Projects which increase shareholder value could be formed with benchmark hurdle rates, the company can ensure a return on projects which results in profitable and competitive advantage.
... Capital, Corporation Finance and the Theory of Investment", The American Economic Review, vol. 48, no. 3, pp. 261-297.
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.
Common stock is a term that is synonymous with investing; it is ownership in a public company. The stock owner is granted voting rights in addition the ability to receive dividends. It is a common terminology that is heard frequently in terms of the daily performance of the stock market whether it was up or down.
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).
You would not buy a home, car or other large purchases without researching what product offered you the most for your money. The same is true when investing in a company. Investors do avid research on multiple companies to find what company matches the investors' criteria. In this paper Team C will research both AT&T and Verizon's financial documents. Team C will compare selected ratios, cash flow and make recommendations how both companies can manage cash flow for the future.
Berk, J., & DeMarzo, P. (2011). Corporate finance: The core, second edition. (2nd ed.). Boston, MA: Prentice Hall.
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.
Brealey, Richard A., Marcus, Alan J., Myers, Stewart C. 1999, Fundamentals of Corporate Finance, 2nd edn, Craig S. Beytien, USA.
Hensel, C. R., Ezra, D., & Ilkiw, J. H. (1991). The Importance of the Asset Allocation Decision.
When compared to the physical capital maintenance concept, the financial capital maintenance concept is the better choice for standard setting when distinguishing between a return of capital and a return on capital. The main argument in favor of physical capital maintenance is that it provides information that has better predictive value, confirmatory value, and is more complete. However, due to agency theory, prospect theory, and positive accounting theory, neutrality and completeness under physical capital maintenance would be impaired so gravely that predictive value and confirmatory value become inefficacious. As a result, financial capital maintenance, with its use of historical cost, is able to provide information to decision makers with stronger confirmatory value and predictive value.
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.