Financial management

Financial Management
Assignment questions
1. You work for a multinational corporation. You are responsible for the assessment of the
corporation’s projects. Explain why the CAPM can be your standard in assessing these
projects and what might be some problems that arise. Elaborate.
2. Explain how you would consider your corporation’s WACC in your projects assessment
above and why it is important. Elaborate.
1/11
Contents
Introduction ……………………………………………………………………………………………………………….. 3
The Efficient Market Hypothesis ………………………………………………………………………………….. 3
Systematic and Unsystematic risk ………………………………………………………………………………… 4
CAPM model uses, assumptions and problems ………………………………………………………………. 4
WACC Implementation ………………………………………………………………………………………………. 7
CAPM versus WACC …………………………………………………………………………………………………. 9
Conclusion ………………………………………………………………………………………………………………… 9
References ……………………………………………………………………………………………………………….. 10
2/11
Introduction
The investment risk of a security and the returns which are expected to be derived from it can
be described by the CAPM model. The model associates the expected return from a security
with the addition of the risk-free rate of return and the risk premium which is derived from the
beta of the asset or the industry. A common observation which can be derived from the CAPM
model is that there is a directly proportional relationship between the returns derived from a
financial asset and the risk associated with it.
On the other hand, the Weighted Cost of Capital, or as otherwise known WACC, is the required
rate of return offered by a company to its shareholders as a way to justify the opportunity of
them holding securities in that company. If shareholders or lenders could receive a better return
elsewhere while taking on the same level of risk, then they would most probably choose to sell
their company shares or not provide funds to the company, to invest their money elsewhere in
an attempt to increase their future earnings.
The Efficient Market Hypothesis
In more recent years, the CAPM model has been a big contributor in the fortifying of the
concept of stock market efficiency. An efficient stock market is dependent on the idea that the
investors participating in the market are mostly rational and that the market prices shares
“correctly” while trading freely without any imposed regulations. In an efficient market, the
market efficiency hypothesis states that it is not possible for an individual to produce returns
above the overall average market returns on a consistent basis. (Institute, 2020).
There are three types of market efficiency, strong form, semi-strong form, and weak form. A
strong form market is when all the information, public and private, is priced in the traded
securities in the market. A semi-strong form market is when the traded security prices include
all publicly available information, and a weak form market is when the traded security prices
reflect past or as otherwise known, historic information. The market we have is said to be semistrong form, hence all publicly available information is priced into the current security prices.
The use of private information for financial gain through the trading of securities is called
insider trading and is illegal (Groww, no date).
3/11
Systematic and Unsystematic risk
What is more, investing in any financial instrument carries systematic and non-systematic risk,
with the first being the risk characteristic of an entire market or a specific asset class, and the
latter being the industry or company specific risk (Surbhi S., 2017). Non-systematic risk can
be completely eliminated through diversification, the investment strategy where a portfolio
contains investments in securities from different industries hence in the event of an economic
downturn affecting a particular company or industry, the rest of the investments in the portfolio
will not be negatively affected. Systematic risk is the result of external factors and cannot be
controlled, minimized or eliminated. It is the risk an investor has to bear in order to gain a
return hence a completely diversified investor’s level of required return on a share is only
affected
by
systematic
risk.
(Vaidya,
2018).
CAPM model uses, assumptions and problems
The CAPM formula is: Rj = Rf + [β x (Rm – Rf)]
Where Rj is the expected return, Rf is the risk-free rate, β is the beta of the asset which
represents the systematic risk, and (Rm – Rf) is the average risk premium. When an asset is
associated with a beta of 1, this generally means that a 1% change in the overall market index,
will lead to a 1% change in the return of the specific asset. Similarly, an asset associated with
a beta of 0, will have returns which are unrelated with the overall market index.
The CAPM model is based on various assumptions such as that:
➢ Investors participating in the market are sensible and reluctant to take risks hence hold
a diversified portfolio.
➢ The market is flawless thus inflation, short selling, and taxes are not taken into
consideration and all information is free and readily available to investors. If the
markets allow for a minority of investors having access to inside information, then the
markets are regarded as inefficient.
➢ There is a risk-free rate, and there are no restraints to borrow and lend at that rate.
➢ All assets are infinitely divisible and can be converted to cash at any time.
➢ Investor expectations about asset returns are similar.
➢ The returns of assets comply with the normal distribution.
4/11
➢ The markets are in a state in which opposing forces are balanced and no single market
participant can have an effect on a security’s price.
➢ Within a defined timeframe, the number of assets on the market in aggregate and their
respective quantities are fixed (Banerjee Probir, 2021).
The CAPM model can be applied in various situations like choosing the best or most suitable
portfolio for investment, identifying shares with incorrect prices, measuring portfolio
performance and in our case, measuring the rate of return on a firm’s projects. The CAPM
model can be applied to determine the expected rate of return for the risk associated with each
of the company’s projects (How to use CAPM for investment appraisal? (3 Methods) CFAJournal, no date). The expected rates of return should be documented for each project and
once the projects are over, these rates should be revisited. The variances between the expected
and actual rates of return for each project should be calculated and where there is a negative
variance, it should be investigated to discover the reasons for the deficit in the rate of return.
Sometimes there are outside factors affecting the calculation of the project returns such as
delays in the project, higher than anticipated project costs or unexpected foreign currency
fluctuations which increase the risk of the project, however some problems are inherent within
the CAPM model.
Firstly, many of the assumptions of the model are unrealistic and do not apply to the overall
market. Not all investors are risk averse or hold diversified portfolios and hence if our company
does not hold a diversified portfolio of projects, the CAPM model will not be a suitable theory
to assess the expected rate of return of our projects. The market is not perfect and if competitors
manage to gain special or inside information with regards to similar projects as our company’s
then this may adversely affect our project’s returns. While the use of insider information is
considered insider trading which is illegal and can lead to fines and/or prison time, it does exist
in the free markets as it has a loose definition and is hard to prove. While in aggregate, insider
trading which is not prosecuted makes a small part of the overall financial markets, in our case
it holds particular importance as if our competitors hold inside information with regards to
specific projects affected by adverse foreign currency fluctuations or higher production costs
they could maximize their returns by investing more in cheaper and less risky projects while
we take on a diversified project portfolio, and loose returns that otherwise would be made if
that inside information was made public at the time (Rajaratnam et al., 2009).
5/11
Furthermore, there is a limit to the amount of financial assistance banks can give to a single
individual or company and it is unlikely that our company can borrow under the risk-free rate,
hence the lowest required return rate which is required by the company may be greater that the
CAPM model incorporation. A better substitute measure to the risk-free rate would be the GOI
bonds yield, however, it is a volatile rate which moves in accordance with the changing
economic circumstances. Adding onto that, the measuring of the beta is also difficult to
calculate, is unstable and varies over time hence it will most likely not reflect the true risk
involved in the project under assessment therefore it is not a good estimate of the future risk
associated with a project. This issue also concerns the discount rate used for the discounting of
the project cashflows.
Depending on the recognized level of systematic risk or as otherwise known in the CAPM
model, the beta (β), the discounted cashflows may vary which makes the project assessment
more difficult and involves more judgement hence is subject to bias. If management is
responsible to calculate the discounted cashflows, and their bonus is dependent on how many
project return rates are achieved, they would be incentivized to manipulate the figures in order
to obtain a higher bonus.
Moreover, the CAPM model assumes that the project rate of required return is dependent solely
on the systematic risk associated with it and ignores other factors such as inflation and
dividends which may adversely impact a project’s returns. Especially nowadays, with the
current economic situation, ignoring the effect of inflation in the assessment of project returns
would be economical suicide since a project yielding 4,5% returns with minimal risk would be
a sound investment but taking into account the current inflation figures of 4,82% in 2021 the
project would generate negative returns and thus should not be implemented (Cyprus Inflation
Rate | 2022 Data | 2023 Forecast | 1951-2021 Historical | Calendar, no date).
Finally, the model concentrates on a single time horizon, suggesting that market participants
are exclusively concerned with the production of wealth from their portfolio by the end of the
current period, which is not the case in the real world (Elearnmarkets, 2021). Different
investors have different time horizons depending on their investment strategy and their
personal and financial goals.
6/11
WACC Implementation
The Weighted Average Cost of Capital (WACC) should be taken into consideration in addition
to the CAPM model when assessing a company’s projects. The WACC shows the minimum
required rate of return for investing in the company’s projects. It is calculated by comparing
the return rates of different alternative project investments that the company can make which
carry the same risk.
The WACC is calculated by the following formula: (Ke x We) + (Kd (1 – T) x Wd) Where Ke
is the equity cost, We is the equity weight, Kd is the debt cost, Wd is the debt weight, and T is
the tax percentage paid. The cost of debt can be calculated by adding the risk premium
associated to an asset to the risk-free rate. Therefore, riskier projects will need to provide a
higher return to justify taking on the higher risk.
Analyzing the WACC formula, we can observe that debt, equity and the required rate of return
are directly proportional. While increasing the equity cost increases the required return rate,
any dividend payout cannot be used to decrease the yearly taxed profit. On the other hand, debt
provides a tax shield advantage, due to the annual interest paid on the loan being deducted from
the annual profits, thus we reach the conclusion that projects financed by debt will need to
provide a lower rate of return than projects financed by equity. This would justify increasing
gearing levels to maximize value while minimizing the required rate of return.
Unfortunately, high gearing levels are an indication of financial distress and increase the risk
of company liquidation. This results in gearing levels being directly proportional to the
probability of equity investors receiving poor or even no returns. Consequently, at high gearing
levels the risk premium rises exponentially which increases the equity cost and thus the
required return rate which more than neutralizes the advantage of enlarging debt in the capital
structure.
There is an optimal gearing level which leads to the lowest WACC with the greatest firm value.
The traditional theory states the existence of an optimal gearing level where WACC is
minimized but does not provide a way to pinpoint it other than trial and error. Modigliani and
Miller first approached the gearing point without taking tax into account in 1958 and concluded
that the WACC is unaffected by changes in gearing and therefore a company can use any
mixture of debt and equity to minimize it. In 1963, Modigliani and Miller reconsidered their
approach to gearing and taking taxation into account concluded that increasing the gearing
7/11
levels makes the WACC smaller while increasing the market value of the company with the
best capital structure being with a 99.9% level of gearing.
However, in the real world, high gearing levels increase the risk of liquidation and hence the
cost of equity. What is more, the tax shield can only be used to offset yearly profits, thus if
there is no profit for the year interest charges will result in a yearly loss with no tax liability to
offset (Kaplan Financial, 2012).
The optimal gearing ratio is first and foremost determined by the particular company in relation
to other companies from the same industry, although the general guidelines are that a gearing
of more than 50% makes a company highly geared and carries increased financial risk, while
a gearing of less than 25% makes a company lower risk. This leads us to believe that the optimal
gearing ratio lies in the range between 25%-50% for most companies with a few exceptions
depending on the industry (Claire, 2021).
The WACC can help minimise management bias in the calculation of the discounting factor of
future cashflows. It can also give an idea to the company of how to compose its capital structure
to finance its projects. The ideal scenario would be where gearing is optimised while the
WACC is minimised which would maximise company returns. A big advantage of using the
WACC is its simplistic approach to evaluating new projects. This means that a manager
wouldn’t require any additional training to perform the calculation and would just need to input
in the formula the weights of each source of finance to derive the result.
For projects involving risk of the same nature, if the current capital structure was unchanged,
the same WACC calculation can be utilized for all of them and this can lead to faster decisions
which would allow for more opportunities to be taken advantage of (Management, 2021).
8/11
CAPM versus WACC
The CAPM model can be utilized within the formula of the WACC to calculate the equity cost
of a project, while the WACC moves on to calculate all the sources of capital cost of the
company. An important distinction between the two models is their uses. The WACC is used
to calculate the minimum required rate of return, the discount rate of future cashflows for a
project, while the CAPM model is used to calculate the expected return of a project and the
cost of equity. CAPM is better suited for projects which are of different risk natures or use
mostly equity, while the WACC is of better use for projects which have similar nature of risk
(What is the Difference Between CAPM & WACC? – Speck & Company, 2021).
Conclusion
Despite the aforementioned problems with the CAPM model, it should be the standard in
assessing the projects that the company will take on, in order for the calculation of whether the
return which is expected from the chosen projects is in line with the company’s future goals
and targets. As a first step, in combination with the WACC, the expected return rate from the
CAPM calculation should be compared to the required rate of return from the WACC
calculation. Any projects for which the CAPM is below the WACC should be automatically
eliminated, with the remaining projects being ranked in accordance to a CAPM/WACC ratio
with the best value project having the highest CAPM/WACC ratio. Other financial and nonfinancial factors should also be considered in the project assessment such as where a project of
low CAPM/WACC ratio will aid in future projects and increase profitability in the long-term.
9/11
References
[1] Banerjee Probir (2021) Assumptions of Capital Asset Pricing Model (CAPM). Available at:
https://www.tutorialspoint.com/assumptions-of-capital-asset-pricing-modelcapm#:~:text= Assumptions of Capital Asset Pricing Model %28CAPM%29,expectations
of risk and return of… More (Accessed: 4 January 2022).
[2] Claire (2021) ‘What Is a Good or Bad Gearing Ratio?’, Investopedia, p. 1. Available at:
https://www.investopedia.com/ask/answers/121814/what-good-gearing-ratio.asp
(Accessed: 4 January 2022).
[3] Cyprus Inflation Rate | 2022 Data | 2023 Forecast | 1951-2021 Historical | Calendar (no
date). Available at: https://tradingeconomics.com/cyprus/inflation-cpi (Accessed: 7
January 2022).
[4] Elearnmarkets (2021) Capital Asset Pricing Model (CAPM) – Calculation, Advantages,
Problems. Available at: https://www.elearnmarkets.com/blog/capital-asset-pricing-modelcapm/#problems (Accessed: 4 January 2022).
[5] Groww (no date) Market Efficiency – Definition, Types & Features of Market Efficiency.
Available at: https://groww.in/p/market-efficiency/ (Accessed: 4 January 2022).
[6] How to use CAPM for investment appraisal? (3 Methods) – CFAJournal (no date).
Available at: https://www.cfajournal.org/use-capm-investment-appraisal/ (Accessed: 4
January 2022).
[7] Institute, C. F. (2020) Efficient Markets Hypothesis – Understanding and Testing EMH.
Available
at:
https://corporatefinanceinstitute.com/resources/knowledge/trading-
investing/efficient-markets-hypothesis/ (Accessed: 4 January 2022).
[8] Kaplan Financial (2012) Theories of gearing, Kaplan Financial Knowledge Bank.
Available
at:
https://kfknowledgebank.kaplan.co.uk/financial-management/corporate-
financing/theories-of-gearing (Accessed: 4 January 2022).
[9] Management, F. (2021) Evaluating New Projects with Weighted Average Cost of Capital
(WACC),
Finance
Management.
Available
at:
https://efinancemanagement.com/investment-decisions/evaluating-new-projects-withweighted-average-cost-of-capital-wacc#Prompt_Decisions_Making (Accessed: 7 January
2022).
[10]
Rajaratnam, R. et al. (2009) ‘Why Insider Trading Is Hard to Define , Prove and
Prevent’, pp. 1–4. Available at: https://knowledge.wharton.upenn.edu/article/why-insidertrading-is-hard-to-define-prove-and-prevent/ (Accessed: 7 January 2022).
10/11
[11]
Surbhi S. (2017) Difference Between Systematic and Unsystematic Risk (with
Comparison Chart) – Key Differences. Available at: https://keydifferences.com/differencebetween-systematic-and-unsystematic-risk.html (Accessed: 4 January 2022).
[12]
Vaidya, D. (2018) Systematic Risk vs Unsystematic Risk | Top 7 Differences
(Infographics), WallStreetMojo. Available at: https://www.educba.com/systematic-riskvs-unsystematic-risk/ (Accessed: 4 January 2022).
[13]
What is the Difference Between CAPM & WACC? – Speck & Company (2021).
Available at: https://speckandcompany.com/capm-vs-wacc/ (Accessed: 4 January 2022).
11/11
…