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MCR006 Financial Management Research Report 2 Sample

This assessment consists of one part a research-based topic.

Part A 40 marks weight 20%

Students will be required to research the topic relating to the concept of the definition and application of the CAPM (Capital Asset Pricing Model) model. Explain the concept of the Capital Asset pricing Model (CAPM) and how it is utilised to determine the required return on a share. Explain why Beta is important and how it is calculated.

Required

a) The paper should include information about how CAPM is calculated and how it is applied and interpreted. One to one and a half(11⁄2) pages. Students should research and provide a minimum of 3 referneces.20 marks

b) A final requirement is to calculate the three-year Beta for a publicly listed company from those companies listed on the ASX. 20 marks

c) Students can use an excel spreadsheet to calculate an provide detail in the report using a snapshot into the word document and provide a brief explanation of the company and a brief interpretation of your calculation. (Half page for calculation and half page for brief description of company and interpretation).

Solution

1. Introduction

CAPM or Capital Asset Pricing Model represents the type of financial model that is used by corporate finance for describing the relationship of security risks and the market. “Investment bankers” use it for analyzing individual stocks and portfolios. In this study, the application and concept of CAPM is being calculated. For Assignment Help, The three-year Beta of IBM Technology Corporation for 2021, 2022 and 2023 is being calculated. The required return on share is being calculated and the interpretation and calculation of CAPM is evaluated.

2. Application and Concept of CAPM

CAPM helps in calculating the expected rate of return from investments that is used for determining the prices of individual securities like stocks. As an important part of “corporate finance” and “investment banking”, CAPM looks at the relationships between the riskiness of the investment and the inherent risk of the market at large. The “Capital Asset Pricing Model” is considered a “theoretical pillar” in “modern finance” (Andrei et al., 2021).

 

Figure 1: Capital Asset Pricing Model
(Source: Wallstreetprep, 2023)

CAPM models help in describing the relationship between the risk of investing and the expected return on security. It helps in showing that the “expected Return on security” is considered equal to the “risk-free return” plus a premium that is based on a “beta of the security”. CAPM helps in creating an idealized portrayal of the financial markets regarding price securities and determining the “expected return on capital investments”. It provides a methodology for translating quantifying the risk to estimates of expected return on Equity. Capital Asset Pricing Model is one of the most used asset pricing models in modern securities theory (Latunde et al., 2020).CAPM helps in evaluating the fair value of the stock when the risk changes and other factors in the market make the investment riskier. CAPM provides a way for estimating the “required return” required. Modern CAPM models are considered the first equilibrium models for the “pricing of financial assets” and the “first asset pricing models” for maximizing investors' utility under various conditions (Chen et al., 2021). Investors tend to implement their “investment decisions” for building “efficient portfolios” in the case of a "mean-variance framework” (Ayub et al., 2020).

3. Three-year Beta of IBM

 

Figure 2: Three-year Beta Chart of IBM
(Source: Self-created)

Beta is considered the measure of a volatile and systematic “risk portfolio” in comparison to the market as a whole which is used for evaluating “capital assets”. The “Beta Capital Asset pricing model” helps describe the relationship of the “expected return” and “systematic risk”. It is used as a method for pricing “risky securities” and for “generating estimates” of the “expected return of assets” by considering both the “risk of the assets” and the “cost of capital”. The “three-year Beta” of IBM for the years 2021, 2022 and 2020 came at -.42. As the Beta turned out to be negative, it implies that the stock price of IBM moved in the market opposite direction. It indicates an inverse relation to the market.

4. Evaluating Required Return on Share

For calculating the required rate of return it is important to subtract the “risk-free rate of return” from the “market rate of return”. The CAPM model helps in providing useful outcomes for the required stock returns. For calculating the expected return on an Asset it is required to utilize the CAPM formula: “Expected Return=Risk free rate+ volatility/beta*(market return-risk free rate”. For calculating the “cost of Equity” using the CAPM formula the rate of return a company will pay to its equity investors. For the companies that pay dividends, the dividend capitalization model can be used for calculating the “cost of Equity”. CAPM metric helps in calculating other financial metrics. It is being used for calculating the expected return in comparison total cost of capital and the risk of assets. CAPM requires the “rate of return” on the general markets, the “beta value” on the stock known as the “market risk premium”. Ways to predict the “expected return on share” is to compute the “mean of share prices” (Liew, 2020). The “beta of the share” helps in describing the relation of the returns with that of the financial market and the volatility provided as a measure which will help in providing an idea of how far the stock will fall.

5. CAPM calculation and interpretation

CAPM formula is: “Expected Return on Investments”=”the risk-free rate the beta (or risk) of the investment”*the “expected return on the market” –“risk-free rate”. For calculating the CAPM Beta, it is required to subtract the “expected market return” from the “expected investment return” which is the dividend as the result of “market return minus the risk returns”. In the case of CAPM interpretation, the returns that are related to the security with a Beta of 1.0 will help in exhibiting returns in line with the broader market. A higher Beta implies Greater potential returns and risks. The company with the highest potential returns process the highest Beta.

The “overvaluation” and “undervaluation” of CAPM is a critical concept. If the rate of return is considered, more than the “expected return” then it will be considered as an “overvalued security”. If the “rate of return” is considered less than the “expected return”, it will be regarded as an “undervalued security”. CAPM formula will help in evaluating the share value when the risk and time value of the money are being evaluated in comparison to the expected return. An important aspect of CAPM denotes the concept of “undervalued and overvalued securities” as the “rate of return” is considered greater than the “expected return” which will be considered as an “overvalued security”.

6. Conclusion

CAPM plays an important role in evaluating whether the stock is valued or not when the “time value” and “risk” of the money are being compared. With the “expected return”, it is possible to evaluate whether the “current price” of the stock is found to be accordant with the “likely return”. CAPM helps in estimating the return on capital investments. The “three-year Beta” of IBM came at the negatives while implying the price movements are against the market trend.

7. Reference List

 

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