1. Capital Asset Pricing Model PWC Course Notes P11 Mark Fielding-Pritchard mefielding.com1

2. CAPM- Gives Us Required rate of Return for Equity  Follows on from Portfolio Theory  Therefore the best combination of risk and return is represented by the market portfolio  Perfect information  Investors are risk adverse  Risk can be calculated in terms of the market portfolio and therefore measured  Risk can therefore be quantified and measured mefielding.com2

3. CAPM  A share has a risk and reward  Anyone purchasing a share will own a diversified portfolio of shares  Risk can be split into market risk and inherent (specific) risk- systematic and unsystematic risk  In terms of the portfolio the specific risk (unsystematic) is immaterial as it will be diversified away  Risk therefore is calculated as the relationship between the risk of the share and the market portfolio  Based on the risk we can calculate the required rate of an investor. That required rate of return is the company’s cost of equity capital mefielding.com3

4. CAPM Risk Measurement  The risk is measured as the relationship between the return on the share and the return on the market portfolio mefielding.com4

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6. Calculation of Beta mefielding.com6

7. Capital Asset Pricing Model Formula E(Ri) = R + β E(R ) - R imf f In words: Required rate of return of investor buying share in company J= cost of equity for company J Required Rate of Return in J = Risk free rate of return + [(return on market portfolio –risk free rate) β] β= equity beta for company J mefielding.com7

8. How To Use CAPM  Dave’s portfolio is yielding 12% per annum currently, Dave wants to know whether to invest in company J  The market portfolio is yielding 8% per annum, twice the risk free rate. J’s Beta is 1.2  RRR = 4 + 1.2(8-4)= 8.8%  Therefore a rational diversified investor would require (will earn) a return of 8.8%  Current portfolio yield is 12% so ….. Note. 8.8% is also the discount rate J should use to discount project appraisals where the project is 100% equity funded mefielding.com8

9. Assumptions of CAPM  Single index  Single period  No tax  Perfect markets  No information  Doesn’t work, α (alpha) values mefielding.com9