Capital Asset Pricing Model - Research Paper Example

Introduction Risks are normal circumstances that can either bring failure or success. It has been well-documented that organisations have consideredrisk mitigation and prevention as utmost priorities. Indeed, firms are working towards certainty and risks are controlled and eventually eliminated from the picture. Despite these efforts, it is evident that risks remain a vital and its mitigation needs to be properly consummated. Aside from these concepts, the financial world is also familiar with the term uncertain. Essentially, this refers to the incapability of providing comprehensive list of outcomes and indefinite probabilities. In most business, risks are often associated with each venture that entities partake. Logically, every endeavour can be affected by several stressors and will result to unsure forecasts. Indeed, firms are unaware of the exact benefits that an investment despite the forecasts provided by financial analysts. In determining the return that investments will likely provide, organisations make use of cash flows. Comparing the cash the flowed out from the investment to the cash that flowed in because of the investment appears to be a near accurate approach that results to better understanding of investment returns. Basically, there are certain tools and mechanisms used by firms to justify the use of cash flows. In particular, discounted multi-period risky cash flows are used to determine benefits coming from investments. Accordingly, the capital asset pricing model is one option that most financial analysts prefer. The succeeding discussions will tackle on the use of capital asset pricing model as basis for discounted multi-period risky cash flows. Capital Budgeting Models The prevalence of investments has led to several ideas particularly on the side showing benefits attributed to such activities. For investors, it is important to determine the exact amount that will be gained from the investment. Essentially, there were several methods developed to address this need. Taggart (1999) created capital budgeting analysis model that makes use of the discounted cash flow. Accordingly, this model enables investors to forecast the values of cash flow components. Among the models, this is considered as widely used because of the perceived precision. Another useful model was developed by Mahoney and Kelliher (1999), which focuses on the capital budgeting model that integrates uncertainty in the cash flow estimates. Using the Monte Carlo simulation, the model can serve as a practical and useful tool. The model, however, is embedded with higher level of complexity that can affect capital budgeting decisions. Moreover, Winston (1998) devised a model for multi-period capital budgeting using Silver Tool, which is an application in Excel. The model provides several advantages including selection of the best project considering all constraints and circumstances. Aside from the mentioned models, Ragsdale (2001) illustrated a model that uses Solver to determine optimal combination of capital budgeting investments as affected by capital constraints and maximising the Net Present Value. In this process, optimal selection of investment is ascertained considering vital risks that include the probability of success of minimum and maximum revenues with the other aspects previously mentioned. Data tables, as showed by Benninga (2000) can be used in capital budgeting analysis. The process involves computing for the point estimate of NPV, and the NPV is calculated using predetermined growth rates. The results are useful in evaluating the risk of the project with the given NPV ranges. Interestingly, Mayes and Shank (2001) focused on the use of different applications for capital budgeting analysis. This involves the collaboration of the models presented earlier in this discussion. Part of their model was to incorporate risk-adjusted discount rates and Monte Carlo simulation to evaluate project risks. According to Fama (1970), multi-period investment consumption can be associated with an individual's wealth. This process is cyclical and can vary in allocation depending on the priorities of the individuals. The decision whether to consume or investment has to be made at the beginning of each periods. In deciding for an investment, the objective of the decision maker remains as the most beneficial basis for making choices. In deciding for projects, it is imperative to give importance to risk aspects. Such recognition will allow decision-makers to decide on which investment to venture. For investors, the investment process constitutes several activities. The first deals with the mapping of project concepts. The second activity is providing forecasts of cash flow for the activity. This is a comprehensive process that uses several instruments and mechanisms. The final phase is related to the identification of project value. Indeed, this takes into consideration the manner in which the distribution process in manifested. Multi-Period Cash Flows Projects vary in periods and most usually last longer than one period. Uncertain cash flow is assigned for each period showing the value of the project after the periods have been exhausted. It has to be noted that the value is incremented as the project progresses. The project has to be pursued once the accumulated value after the last period is greater than the initial capital outlay. Basically, the value is determined by the cash flow in each of the period. It is imperative, however, to consider risks in the cash flow because it will accurately determine the real value of the project after the last period. In general, the structure of multi-period project assessment is lucid. On the other hand, the solution to the problem in terms of currently known values and estimates suggest otherwise. In using single cash inflow in two periods, the value of the uncertain cash flow two periods in the future is provided by the current expectation of the flow less three premiums discounted at the product and current risk-free rate with the second periods expected risk-free rate. Basic emphasis of the model is that reduction of risk is manifested though the use of diversification schemes (Bogue and Roll, 1974). Aside from the given risks, the model computes for interest rate risks. This is done to determine the effect of interest rate change on the value of the project in intermediate periods. This considers the condition that the probability assessment of the project cash flow remains constant. Indeed, it is possible the interest rate will change the value of the project as the period progresses. This realistic view makes the project value more accurate. Asset Valuation Methods It has been mentioned that single-period representation of uncertainty is unsuited for the assessment of projects that run in multiple periods. In particular, it is necessary to consider the period-by-period variation in the structure of risk in order to give appropriate weight to long-term cash-flows or to support analysis of operating flexibility (Laughton, 1991). Moreover, even in the absence of these considerations a constant discount rate framework can bias the comparison of project alterative. In this situation, it is best to use methods that best capture the situation. Identifying the projects requires more than the figures and risks that are reflected in the cash flow. Given this consideration, it was suggested the options theory of valuation be used. It assumes that valuation can be undertaken assuming that financial markets are competitive and protected from transaction barriers. In the mentioned markets, assets of different nature with the similar cash flow consequences have similar price. In addition, the market enables the replication of cash flow consequences. All asset prices are ascertained by the risk preferences of investors, as reflected in markets. The basic assets that provide information about risk discounting are those that have some direct interaction with future macroeconomic variables. Stages in the analysis are essentially the same as in current practice, including the formulation of decision alternatives, the determination of key uncertainties, and the layout of a cash-flow model. The results come in a familiar form: simulations of project cash-flows and representations of their statistics Capital Asset Pricing Model Capital asset pricing model (CAPM) is a theoretical model that ascertains the correct rate of return of an asset. It follows the condition that the asset is to be supplemented in a well-diverse portfolio and the asset has no-diversifiable risks. Using the security perspective, the security market line was used in connection to expected return and systematic risk to illustrate the manner in which market will price individual securities considering their risk classifications. In addition, the security market line enables analysts to compute the reward-to-risk ration for any security in relation to the overall market (Ross, 1977). CAPM allows the future cash flows of the asset to be discounted to their present value using the expected return rate. This is undertaken to establish the correct price of the asset. Theoretically, hence, the asset is accurately priced when it observed price is similar as its value computed using the CAPM derived discount rate. When the observed price is higher than the valuation, then the asset is overvalued. Another option to solve for the discount rate for the observed price is to give the valuation model and compare the CAPM rate to the discount rate. Lower discount rate compared with the CAPM means overvalued asset. The CAPM when used has the capacity to return the asset appropriate required return or discount rate. For instance, the rate at which future cash flows produced by the asset has to be discounted considering the asset's relative risk. Basically, CAPM conforms to the perception of investors that holding high risk assets provide higher returns (Sharpe, 1964). This contention was made clearer by the reality that high risk assets have high discount rates. In the context of CAPM, risks are classified as systematic and specific. Systematic risk deals with the risk common to all securities. On the other hand, specific risk is the risk associated with individual assets. The major difference is that specific risk can be diversified, while systematic risk cannot. Depending on the market, a portfolio of approximately 15 well selected shares may be adequately diversified to leave the portfolio exposed to systemic risk. In markets, only non-diversifiable risks are provided with rewards. Indeed, the required return on assets has to be related in the portfolio. Normally, CAPM shows that portfolio risks are in higher variance (Lintner, 1965). CAPM has several assumptions and serve as basis for its use. First, all investors have rational expectations. This means that the investors make the optimal forecast in relation to their project. Second, CAPM follows no arbitrage opportunities. Therefore, the investors are unable to take advantage of different price between markets. Third, returns of asset are distributed normally. Essentially, this concept follows equitable distribution of benefits. Fourth, the quantity of asset is fixed. Computing for CAPM needs to establish an amount that will serve as the fixed value (Black, Jensen, and Scholes, 1972). Moreover, CAPM assumes that the capital markets are in perfect conditions. This is actually done to determine the impact of risks more accurately. In addition, the financial and production sectors are distinctively identified. The risks free rates are existent given the unlimited borrowing capacity and access. Most important, CAPM considers no inflation and assumes that the level of interest rate remains unchanged. Analysis Evidently, using CAPM appears to be appropriate in discounted multi-period risky cash flows. Basically, the argument for this notion can be supported by the assumptions promoted by CAPM. In multi-period cash flows, it is expected that the invertors will have rational expectations. Cash flows are based on the forecast that are in the optimal level. It is important to consider the cash flow that is perceived to provide maximum benefits to the company. In such manner, the analysts can easily determine the discount that best depicts the true value of the project after the periods are finished. Indeed, arbitrage has no place in discounted cash flows in multi-periods. Because the process is risky, it has to eliminate the capacity of the investors to consider changing market prices of assets. In the process, the risk involve has to be solely related with the value of the project. The inflow of benefits coming from the project needs to be shielded from other forms of risks. Arbitrage allows investors to test the project in different markets thus affecting the value of the asset. Basically, the asset needs to be gauged in a situation where prices are constant and fixed. Because the cash flow is multi-period, the benefits of the asset need to be distributed equitably. This method makes the discounted cash flow in multi-period balanced. Normally, assets provide equal benefits in long periods. Such is reflected in the cash flow that shows equal amount of cash coming from the use of the asset. Over long periods, the assumption will help in accurately determining the benefits of the asset. Myers and Turnbull (1977) mentioned that the forecast of investors on the cash flow of firms is based on adaptive expectation models. An expression is derived for the value of the firm's asset and the systematic risk. It has been argued that the value of uncertain cash flow has to be related to certain underlying variables. The variables operate in continuous time and derive partial differential equation describing the market value of the cash flow given an exogenous risk premium. This has been parallel to the central ideas discussed in the previously. Risks have to be generally discussed because the values in the cash flow will be affected one diversified risks come in. Accordingly, CAPM can develop simple and general valuation formulas. These formulas are proven to effective in capital budgeting. These formulas are based on the discounted cash flow formula and risk-adjusted discount rates. Definitely, combining the two aspects agrees to the idea that CAPM is a valuable tool that can be used in discounted multi-period risky cash flow. Aside from the simplicity, it is imperative that the process allows for certain changes within the process of providing the cash flow. CPAM has been a flexible tool that provides theoretical perspective helpful for firms. Overall, CAPM has become a valuable mechanism in asset valuation and capital budgeting. Specifically, the process that requires multi-period cash flow is related with the idea of CAPM. The underlying attributes and assumptions promoted by CAPM suggest linkage in which the process of the discounted multi-period risky cash flow is undertaken. The method allows analyst to make careful judgments and wise financial decisions. Conclusion For most firms, investment is an essential component of the operations. Its financial facet is an intriguing part that is both simple and complex. Capital budgeting is considered as a primary activity when it comes to investments. It is believed that the value of the investment is determined by such process. In the previous discussions, there were several methods used for capital budgeting. Basically the processes have evolved considerable since risks have been recognised. Also, most framers have realised the value of other aspects including the method used for determining investment value. It has been discussed that CAPM has been used to support the use of discounted multi-period risky cash flow. The assumptions used in the latter have been also adaptable in the former. In addition, the ideas promoted by CAMP have been attributable to the cash flow method. Basically, asset pricing is both benefits and risks. Moreover, such process can be better comprehended in multi-periods. CAPM, in addition, assumes several situations that make the cash flow values highly realistic. These are the fundamental concepts that make CAPM an accurate determinant of cash flow value. Undeniably, there are several loopholes that critics identified in using CAPM. It has been argued that some assumption of CAPM are unrealistic and at some instances inapplicable to capital budgeting. Despite these claims, the arguments presented including the comprehensive discussion of CAPM and the cash flow is sufficient to underline the general contention that CAPM supports the use of discounted multi-period risky cash flow. References Benninga, S. (2000). Financial Modelling, Second Edition. Cambridge, MA: The MIT Press. Black, F., M. Jensen, and M. Scholes. (1972). The Capital Asset Pricing Model: Some Empirical Tests. "Studies in capital theory markets." Bogue, M. and R. Roll. (1974). The Journal of Finance. "Capital budgeting of risky projects with imperfect markets and risky capital." Fama, E. (1970). The American Economic Review. "Multi-period consumption investment decisions." Laughton, D. (1991). The Valuation of Off-shore Oil-field Development Leases." Paris: Editions Technip. Lintner, J. (1965). Review of Economics and Statistics. "The valuation assets and the selection of risky investments in stock portfolios and capital budgets." Mahoney, L. and C. Kelliher. (1999. Journal of Financial Education. "Teaching tools to deal with the uncertainty inherent in capital budgeting models." Mayes, T and T. Shank. (2001). Financial Analysis with Microsoft Excel, Second Edition. Orlando, FE: Harcourt, Inc. Myers, S. and Turnbull S. The Journal of Finance. "Capital budgeting and capital asset pricing model: Good news and bad news." Ragsdale, C. T. ( 2001). Spreadsheet Modelling and Decision Analysis, Third Edition. Cincinnati, OH: South-Western College Publishing. Ross, S. (1977). Journal of Finance. "The Capital Asset Pricing Model: Short sale restrictions and related issues." Sharpe, W. (1964). Journal of Finance. "Capital asset prices: A theory of market equilibrium under the condition of risk." Taggart, R. (1999). Financial Practice and Education. "Spreadsheet exercises for linking, financial statements, valuation and capital budgeting." Winston, W. (1998). Financial Models Using Simulation and Optimization, Newfield, NY: Palisade Corporation. Read More