1 Chapter 13: The Capital Asset Pricing Model Copyright © Prentice Hall Inc Author: Nick Bagley, bdellaSoft, Inc. Objective The Theory of the CAPM Use of CAPM in benchmarking Using CAPM to determine correct rate for discounting

2 Chapter 13 Contents 13.1 The Capital Asset Pricing Model in Brief 13.2 Determining the Risk Premium on the Market Portfolio 13.3 Beta and Risk Premiums on Individual Securities 13.4 Using the CAPM in Portfolio Selection 13.5 Valuation & Regulating Rates of Return

3 Introduction CAPM is a theory about equilibrium prices in the markets for risky assetsCAPM is a theory about equilibrium prices in the markets for risky assets It is important because it providesIt is important because it provides –a justification for the widespread practice of passive investing called indexing –a way to estimate expected rates of return for use in evaluating stocks and projects

4 CML Formula

5 Determining the Risk Premium on the Market Portfolio CAPM states thatCAPM states that –the equilibrium risk premium on the market portfolio is the product of variance of the market,  2 Mvariance of the market,  2 M weighted average of the degree of risk aversion of holders of risk, Aweighted average of the degree of risk aversion of holders of risk, A

6 Example: To Determine ‘A’

7 CAPM Risk Premium on any Asset According the the CAPM, in equilibrium, the risk premium on any asset is equal the product ofAccording the the CAPM, in equilibrium, the risk premium on any asset is equal the product of –  (or ‘Beta’) –the risk premium on the market portfolio

8 The Beta of a Portfolio When determining the risk of a portfolioWhen determining the risk of a portfolio –using standard deviation results in a formula that’s quite complex –using beta, the formula is linear

9 Computing Beta Here is a useful formula for computing beta:  i =  i  M  iM /  M 2Here is a useful formula for computing beta:  i =  i  M  iM /  M 2

10 Valuation and Regulating Rates of Return Beta may be used to obtain the discount factor for a projectBeta may be used to obtain the discount factor for a project Assume a project is similar to the projects undertaken by another firm, ‘Betaful’Assume a project is similar to the projects undertaken by another firm, ‘Betaful’ Betaful is financed by 20% short-term debt, and 80% equity. Its equity  is 1.3 and debt is risk-free.Betaful is financed by 20% short-term debt, and 80% equity. Its equity  is 1.3 and debt is risk-free. Your optimal capital structure is 40% (risk- free) debt, and 60% equityYour optimal capital structure is 40% (risk- free) debt, and 60% equity

11 Valuation and Regulating Rates of Return Assume the market rate is 15%, and the risk- free rate is 5%Assume the market rate is 15%, and the risk- free rate is 5% Compute the beta of betaful’s operationsCompute the beta of betaful’s operations

12 Valuation and Regulating Rates of Return Beta of betaful’s operations is equal to the beta of our new operationBeta of betaful’s operations is equal to the beta of our new operation To find the required return on the new project, apply the CAPMTo find the required return on the new project, apply the CAPM

13 Valuation and Regulating Rates of Return Assume that your company is just a vehicle for the new project, then the beta of your unquoted equity isAssume that your company is just a vehicle for the new project, then the beta of your unquoted equity is

14 Valuation and Regulating Rates of Return Assume that your company has an expected dividend of $6 next year, and that it will grow annually at a rate of 4% for ever, the value of a share isAssume that your company has an expected dividend of $6 next year, and that it will grow annually at a rate of 4% for ever, the value of a share is