C08_ST_CORP_FIN_MAN_9781860724237.

QXD:ICSA 17/6/09 10:25 Page 131

chapter 8

The capital asset

pricing model

contents
1 Risk 5 The capital asset pricing model and
2 Calculation of betas portfolio management
3 Validity of CAPM assumptions 6 The arbitrage pricing model
4 Testing and use of CAPM

learning outcomes
After reading and understanding the contents of this chapter and working through all the
worked examples and practice questions, you should be able to:

䡲 Distinguish between systematic and unsystematic risk.

䡲 Measure systematic risk in relation to market risk and represent the relationship graphically.
䡲 Understand how the beta factor is calculated and how it measures a share’s volatility.
䡲 Use the CAPM formula to relate the return on a share to the risk-free rate of return and the
market rate of return using the beta factor.
䡲 Calculate the beta and return for a portfolio.
䡲 Discuss the validity of the assumptions underlying the CAPM and its practical application.
䡲 Be aware of the arbitrage pricing model and why it was developed.
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 132

132 COST OF CAPITAL AND CAPITAL STRUCTURE

Introduction
In chapter 7 we discussed portfolio theory, which underpins the capital asset
capital asset pricing pricing model (CAPM). CAPM was developed by Sharpe and Litner building on the
model (CAPM) Equation work of Markowitz and portfolio theory.The model brings together aspects of share
expressing the relationship valuations, the cost of capital and gearing and thus has important implications for
between the degree of risk of
financial management.
an investment and the
expected return on the
For our purposes, we can make the assumption that there are two basic functions
investment. associated with the CAPM:
1 attempting to establish the ‘correct’ equilibrium market value of a company’s
shares;
2 calculating the cost of a firm’s equity (and thus the weighted average cost of
capital), as an alternative approach to the dividend valuation model which we
considered in chapter 6.
The model also implies equilibrium between risk and the expected return for each
security and can be used by the financial manager to assess risk in individual
company shares or a portfolio of securities.

1 Risk
There is risk associated with investment in any security and we saw in chapter 7 that
the greater the risk, the greater the required return from the investment. However,
one type of stock which has a low risk, and which is assumed in portfolio theory to
be risk-free, is government stock (because the market is completely confident that
the government will honour its commitments to pay the returns agreed).The differ-
ence between the higher return on another investment and the risk-free rate of return
is known as the excess return (or the risk premium). It differs between securities
depending on the market’s perception of their relative risks.
The only way for an investor to avoid risk altogether is by investing solely in
government securities. However, the cost is a lower return than might otherwise have
been made.
We showed in chapter 6 that risk is both financial and business risk.We have also
seen that investors tend to diversify their portfolios to minimise risk while main-
taining their return. The risk that can be diversified away is known as unsystematic
risk and is unique to a particular company. It is independent of political and econ-
omic factors and may arise, for example, as a result of bad labour relations causing
strikes, the emergence of improved competitor products or adverse press reports. It is
diversified away because the factors causing it are different for different companies:
they are largely uncorrelated and tend to cancel each other out.
The risk related to the market, which is known as systematic or market risk,
cannot be diversified away (if it could, the return on the market would not be higher
than the risk-free rate). Systematic risk is therefore unavoidable. Systematic risk may
arise as a result of government legislation, from adverse trends in the economy or
from other external factors over which the company has no control.
The degree of systematic risk is different for different industries. Shares in
different companies and different sectors have different levels of systematic risk
because some are affected more than others by systematic economic and political risk
factors. For example, food retailing has less systematic risk than the fashion industry:
income and profits vary more with the economic cycle for the fashion industry than
for food retailing. Individual investments have their own levels of systematic or
market risk, depending on how severely individual companies are affected by
political events and economic variations.A portfolio that represents the market, or an
investment in a market tracker fund, is subject to the same systematic risk as the
market as a whole.
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 133

8 THE CAPITAL ASSET PRICING MODEL 133

The difference between the two types of risk (systematic and unsystematic) are
significant, because in constructing a portfolio an investor can minimise unsystem-
atic risk by diversification (which means here increasing the size of the portfolio),
whereas systematic risk can be reduced by selecting investments with a low level of
susceptibility to systematic risk factors rather than increasing the number of invest-
ments in the portfolio.
Research has shown that, if a portfolio consists of between 15 and 20 shares
selected at random, the unsystematic risk of the portfolio should be substantially
eliminated, as we noted in chapter 7 (see Figure 8.1).

figure 8.1 Increasing the size of a portfolio reduces the risk

Standard
deviation
of
portfolio
returns
Unsystematic risk

Systematic
risk
Total risk
Number
of shares
in portfolio

The CAPM assumes that investors have diversified away unsystematic risk, so that the
returns on investments do not compensate investors for this risk. Since systematic
risk cannot be diversified away, investors require an increased return to compensate
for systematic risk, and the prices of securities and the returns that they offer
reflect this.

test your knowledge 8.1

(a) What is systematic risk?

(b) What is non-systematic risk?

1.1 Measuring systematic risk

The CAPM splits the total risk of a security into the unsystematic risk (which is diver-
sifiable) and the remainder.The remainder is the relevant risk for appraising invest-
ments. CAPM is concerned with:
䡲 how systematic risk is measured;
䡲 how systematic risk affects required returns and share prices.
To measure systematic risk, we use the beta factor (β). The CAPM is based on the
assumptions that investors:
䡲 in shares require a return in excess of the risk-free rate (i.e. a premium) as
compensation for taking the systematic risk of the investment;
䡲 should not require a premium for unsystematic risk as this may be diversified and
removed from the portfolio (as discussed earlier);
䡲 will expect a greater return from companies with greater systematic risk (as meas-
ured by their beta factors).
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 134

134 COST OF CAPITAL AND CAPITAL STRUCTURE

The financial manager may also adopt a similar approach to investment in one or
more new projects.When a company is considering an investment in a new project,
there will be a degree of risk involved. The greater the perception of risk in the
venture, the greater will be the expected return (assuming, of course, that the direc-
tors are willing to sanction the investment in the first place).

1.2 Market risk and return

The CAPM was formulated principally to evaluate investments in stocks and shares
traded on the stock market rather than in companies’ investment projects.The model
is based on a comparison of the returns on individual investments and shares with
the return on the market as a whole.
Market risk arises from the variability of the total market return (the return on the
market portfolio – a balanced portfolio that represents all the investments available
in the market). As the components of the market fluctuate constantly, so the market
return and the systematic (or market) risk also vary. CAPM must make a major and
fundamental assumption: that there is a linear relationship between the return on
the shares of an individual company and the return on the market portfolio. It also
depends on estimates of the market return and the risk free rate of return, both of
which vary over time. For these reasons, CAPM is really only useful for single period
time-frames. Its assumptions become less likely to hold good the further ahead
we look.
Let’s look at an example to demonstrate how the return from one investment
compares with the market.

Company A Whole market

Price at start of period £110 £490
Price at end of period £130 £510
Dividend paid £6.5 £40.1

The return on Company A’s shares (Rs) and the return on the general market port-
folio of shares (Rm) can now be calculated as follows:
Capital gain (or loss)  Dividend

Price at start of period

Therefore:

(130  110)  6.5

Rs  –––––––––––––––
110  0.241 = 24.1%

(510  490)  40.1

Rm 

 0.123 = 12.3%
490
Statistical analysis of historical returns from Company A and from the market may
suggest that a linear relationship exists.Thus, the linear relationship can be demon-
strated through collecting comparative figures from Company A and average market
returns (say on a month-by-month basis).The results can then be plotted as a scatter
diagram and a line of best fit drawn with linear regression (see Figure 8.2).This is the
characteristic line.
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 135

8 THE CAPITAL ASSET PRICING MODEL 135

Figure 8.2 illustrates three important points:

figure 8.2 Line of best fit: characteristic line

Return from
company A’s
shares (Rs)

Line of best fit

Return from
whole market
(Rm)

1 The return on Company A (Rs) and the market return (Rm) tend to rise or fall
together.
2 Variations in Rs may be greater or less than variations in Rm because the systematic
risk of an individual security differs from that of the whole market. If the slope of
the characteristic line shown in Figure 8.2 is less than 1.0, the variability due to
systematic risk factors of the return on the share is less than the corresponding
variability of the market return. Company A is an example of an investment
returns of which tend to vary less than the market return and is therefore
considered less risky than the market average.
3 The line may not always fit the points closely – remember that returns are affected
by both unsystematic and systematic risk, and the effect of unsystematic risk may
be large.
Negative returns are also possible. This may happen when A’s share price or the
market index falls, causing a capital loss that can outweigh the dividend return.
Our example demonstrates a fairly close relationship between an individual
company’s return and that of the market.The slope of the characteristic line provides
a measure of the relationship between the return on a company’s shares and the
beta factor (β) A measure of market return.The slope of the characteristic line is the company’s beta factor (ββ).
the relationship between the The steeper the line, the greater the beta factor, and the more the return on the
return on a share and the company’s shares varies in response to the systematic risk factors that affect the
market return. A high beta
share has a high risk and a
whole market.
high expected return to
compensate for this risk. 1.3 The beta factor and market risk
The beta factor is a measure of a share’s volatility in terms of market risk.
䡲 Where β > 1, the shares are described as aggressive: they outperform the market.
This means they give a bigger return than the market when the market return is
positive and a bigger loss than the market when the market return is negative.
䡲 Where β = 1, the shares are described as neutral: their returns are in line with the
average return of the stock market.
䡲 Where β < 1, the shares are described as defensive: they are less risky than the
market generally.
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 136

136 COST OF CAPITAL AND CAPITAL STRUCTURE

The market as a whole has a beta factor of 1. If a company’s beta factor is 2, its return
will vary twice as much as the return on the market as a whole. If the market return
(Rm) is 5 per cent above the risk-free rate of return, then the expected return for this
company with a beta factor of 2 is 10 per cent above the risk-free rate of return. If the
market return is 3 per cent below the risk-free return, the expected return for the
company is 6 per cent below the risk-free return. The actual return for the company
may differ from the expected return because of variations due to the company’s
unsystematic risk, which is unique to the company.
We should remember that CAPM deals only with the risk premium that investors
require because of systematic risk. One of the assumptions on which the CAPM is
based is that unsystematic risk can be cancelled out by diversifying the portfolio.
When we considered investment risk in chapter 7, the risk of an individual or
portfolio investment was measured by sigma (σ), the standard deviation of the
return.This risk included all variability of the return, whether caused by systematic
or unsystematic factors. In the CAPM, risk is assumed to be only systematic, and is
measured by β rather than ∂.
The expected return on a portfolio of shares depends on:
䡲 changes in the market return;
䡲 the beta factors of the shares that make up the portfolio;
䡲 the risk-free return.

worked example 8.1

The return on government stock is 9 per cent.

The average market return is 13 per cent (the excess return is therefore 4 per cent – the difference between
the market return and the risk-free return).
The difference between the expected return on an individual investment and the risk-free return can be
measured as the excess return for the market as a whole, multiplied by the beta factor of the investment.
For example, if a company has a β of 1.4, the expected return on the company’s shares exceeds the risk-free
return by:
1.4 × (13 – 9)% = 5.6%
The total expected return for the company’s shares is:
9% + 5.6% = 14.6%
If the market return falls by 3 per cent (from 13 per cent to 10 per cent), the expected return on the company’s
shares falls by:
1.4 × 3% = 4.2%
The company’s return is now:
14.6% – 4.2% = 10.4%
Put another way, the excess return for the market is now:
10% – 9% = 1%
And the excess return for the company is:
1.4 × 1% = 1.4%
So the return for the company is:
9% + 1.4% = 10.4%
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 137

8 THE CAPITAL ASSET PRICING MODEL 137

1.4 The capital asset pricing model formula and the security
market line
The CAPM formula is based on the concept that the principle that the risk premium
for a secutiy (the excess of the return on the security over the risk free rate of return)
is proportional to the risk of the security, measured by its beta factor:
(Rs – Rf) = β (Rm – Rf)
or:

Rs = Rf + β (Rm – Rf)

where:
Rs = expected return from an individual investment
Rf = the risk-free rate of return
Rm = the market rate of return (the return on the all share index)
β = the beta factor of the investment

theory into practice 8.1

When the market return is 12 per cent, company A’s (b) Company A’s excess return = 1.5 × market
shares give a return of 16 per cent. When the market excess return
return rises to 14 per cent, company A’s shares give a
So before the change:
return of 19 per cent. The risk-free rate of return does
not change. 16% – r = 1.5 (12% – r)

(a) What is company A’s beta value? which gives:

(b) What is the risk-free return? r = 4%

As a check, after the change:
Answer
(a) Since the risk-free rate does not change, the 19% – r = 1.5 (14% – r)
market excess return increases by the same which also gives: r = 4%
amount as the market return: 2 per cent.
Similarly, company A’s excess return increases by
3 per cent. So company A’s beta value is:
3%
–––– = 1.5
2%

1.5 Alpha values

The alpha value of a share is the difference between the actual or projected return on
the share and the return that is required, taking account of its level of systematic risk,
according to the CAPM.
If the actual return, or the return estimated by some other means, is greater than
the required rate of return calculated using the CAPM equation, the alpha value of the
share is positive. It indicates an investment that gives or promises a return greater
than that needed to compensate for risk, and is therefore undervalued.

worked example 8.2

A company’s shares have a beta of 1.2 and an alpha of 12%. The market return is 10 per cent and the risk-free
rate is 6 per cent.
The required return according to the CAPM = 6% + 1.2 (10 – 6)% = 10.8%.
The actual or projected return is 10.8% + 2% = 12.8%
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 138

138 COST OF CAPITAL AND CAPITAL STRUCTURE

theory into practice 8.2

Company B’s beta factor is 1.2, the market return is Answer
8 per cent and the risk-free rate is 4.5 per cent. Company B’s expected return is:
Company B’s return is 9.6 per cent.
1.2 (8.0% – 4.5%) + 4.5% = 8.7%
Calculate Company B’s alpha value.
Company B’s alpha value is:
9.6% – 8.7% = 0.9%

1.6 The CAPM and share prices

The CAPM can also be used to predict share values as well as estimating returns from
investments carrying different levels of risk. This is shown in worked example 8.3.

worked example 8.3

Company A and Company B both pay an annual dividend of 34.04p per share and this is expected to carry on
indefinitely. The risk-free rate is 8 per cent and the average market rate is 12 per cent. Company A’s beta is
1.8 and Company B’s beta is 0.8.

Required

Calculate the expected return for each company to predict the market price of each company’s shares.

Answer

The expected return for A = 8% + 1.8 (12% – 8%) = 15.2%.

The expected return for B = 8% + 0.8 (12% – 8%) = 11.2%.
Using the dividend valuation model, the expected price of the share can be calculated:
34.04
Predicted share value in A = –––––– = 224 p.
0.152
34.04
Predicted share value in B = –––––– = 304 p.
0.112

Note that the share values in worked example 8.3 have been calculated assuming no
growth in dividends, using the formula for a perpetuity. If we expected dividends to
grow and could estimate the expected dividend growth rate, we would use the divi-
dend growth model to calculate the share price.The calculations above assume that
the first dividend will be received one year from now.This means that the share prices
calculated here are ex-dividend prices.

1.7 The CAPM and gearing

You will already be aware that the level of gearing in a company will affect the risk of
its equity. If the gearing changes because the company issues more debt capital, the
risk for equity investors will increase.This extra risk will be reflected by an increase in
the company’s beta factor. Risk-averse investors will find the shares less attractive,
while risk-seekers will find them more attractive and will be rewarded for the higher
risk with a higher return. (We shall look at gearing in detail in the next chapter.)

2 Calculation of betas
We saw in section 1 above that the beta factor for a share is the gradient of the char-
acteristic line - the regression line of best fit found when the returns on a company’s
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 139

8 THE CAPITAL ASSET PRICING MODEL 139

shares are graphed against the corresponding returns on the market portfolio. The
gradient of the regression line (i.e. the beta) is given by:

ssm
β

where:
sm = the standard deviation of the market return
ss = the standard deviation of the return on the company’s shares
rsm = the coefficient of correlation between the return on the company’s shares
and the market return
The correlation coefficient can take values between 11 (for perfect positive corre-
lation) and 21 (for perfect negative correlation) and can be calculated from pairs of
data for the return on the company’s shares and the market return. In calculating beta
values, the market portfolio is often represented by a broadly based share index such
as the FTSE 100 or the All Share Index.

worked example 8.4

Returns on Jack plc’s shares have a standard deviation of 12 per cent – twice as high as that of the market. It is
estimated that the correlation between the market return and Jack plc’s return is 0.45.

Required
If the estimated market return is 15 per cent and the return on government bonds is 6 per cent – calculate:
(a) The beta of Jack plc’s shares.
(b) The cost of equity for Jack plc.

Answer
(a) Using the formula:
ssm


(see above) we can calculate Jack’s beta – remember that Jack’s standard deviation is twice that of the
market and therefore the market standard deviation is 12/2  6.

s sm 12  0.45
 


 0.9
m 6

The beta of Jack plc’s shares is therefore 0.9.

(b) The cost of equity is the return shareholders expect to receive on their shares (i.e. it is the expected return
from the investment) and can be calculated using the capital asset pricing model:

Rs  Rf   (Rm  Rf)

Government debt can be assumed (unless you are told otherwise) to be risk-free and thus the return on it is
the risk-free rate.

Rs  6  0.9 (15  6)  14.1

Therefore the cost of equity for Jack plc is 14.1 per cent.

3 CAPM assumptions
The assumptions on which CAPM is based are set out below, together with some
comments on how far they hold true in practice:
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 140

140 COST OF CAPITAL AND CAPITAL STRUCTURE

1 Investors are rational and require greater return for taking greater risks; empirical
evidence supports this.
2 Individual investors can efficiently diversify away unsystematic risk. There are
many reasons why investors may not diversify enough as required by CAPM. It
requires effort and cost for an investor to manage a portfolio of investments
actively. Investors may not want to diversify from a business that they know well.
Similarly, investors may not wish to be restrained from ‘playing the market’,
whatever the arguments in favour of diversifying away risk.
3 There are equal borrowing and lending rates. Generally, borrowing rates are
higher than lending rates; however, the CAPM can be modified to incorporate
this and the results remain the same.
4 There are no transaction costs – the existence of transaction costs means that
investors may not undertake all required transactions to make their portfolios
efficient. Thus the CML may be a band rather than a line.
5 There are no market imperfections – beyond the very short term, the market
imperfections of lack of divisibility of investments, fixed charges, imperfect
opportunities and imperfect information mean that the model has poor
predictive ability.
6 The model ignores risks of insolvency, which must be considered by the investor.
7 Homogeneous expectations – clearly not all investors have the same view on the
prospects of securities. However, when the assumption is relaxed, the CAPM has
been found still to maintain its predictive abilities.
8 The risk-free rate is assumed to be equal to returns on government bonds, but
there are many different government securities with different rates of return.
9 No taxation – the existence of taxation may mean that shareholders prefer capital
gains to dividends. However, when this assumption is relaxed, the CAPM has still
been found to maintain its predictive abilities.
10 There is no inflation – inflation clearly exists and may be seen as an additional
risk. However, when incorporated into the model, the model can still predict the
required returns accurately.

4 Testing and use of CAPM

CAPM is based on a one-year period; its extension to multiple periods requires the
economic environment and returns on the project relative to the market to remain
reasonably stable. Changing market conditions and changing cost structures in firms
mean that a company’s beta will not remain stable over time. In addition, estimates of
betas are subject to statistical variability. Industry betas may be more reliable than
individual company betas.
It is difficult to test the CAPM because the model deals with expected returns and
all securities and it is possible only to record actual historical results and those
securities included in market indexes. (Market indexes generally contain only a
sample of the securities available to investors.) Empirical research suggests that
although CAPM is not a perfect model of the real world, it does provide a reasonable
model of the risk/return trade-off. For example, while low beta shares do provide
lower expected returns than higher beta shares, low beta shares often provide returns
above and high beta shares returns below those which the model would predict. The
CAPM is used in practice as a decision-making tool in the choice of portfolios in both
the UK and the US.
Each investment or project should have its own discount rate according to its
systematic risk as measured by its beta coefficient. The discount rate in any one year
then depends on the risk-free rate of interest and the market risk premium in that
year. (The ways in which these complexities may be dealt with is beyond the scope of
the present discussion.)
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 15:26 Page 141

8 THE CAPITAL ASSET PRICING MODEL 141

test your knowledge 8.2

Which assumptions of the CAPM may not hold true in practice?

5 The capital asset pricing model and portfolio

management
The capital asset pricing model has several practical uses. Beta factors of individual secu-
rities are published by a number of analysts (e.g. the London Business School) for
investment and other purposes and can be found on a number of financial websites.The
capital asset pricing model can be used by investors when selecting their portfolios of
shares, thus reflecting the individual’s risk preference.A risk-taker would select a port-
folio with a beta greater than 1 (large gains/large losses), whereas a risk-averter would
select a beta equal to or less than 1.A portfolio of securities has a beta factor that is the
weighted average of the betas of the securities within the portfolio.

worked example 8.5

Jessica wishes to know the expected return on her portfolio, when the risk-free rate is 7 per cent and the return
on the market is expected to be 20 per cent. Her portfolio is made up as follows:
Security Percentage of portfolio Beta factor of security
R plc 15 0.2
S plc 10 1.2
T plc 5 1.8
U plc 30 0.9
V plc 25 0.2
W plc 15 0.8

Answer
The portfolio’s beta is the weighted average of the individual betas:
(15% × 0.2) + (10% × 1.2) + (5% × 1.8) + (30% × 0.9) + (25% × 0.2) + (15% × 0.8)
= 0.03 + 0.12 + 0.09 + 0.27 + 0.05 + 0.12
= 0.68
The expected return on the portfolio is:
Rp = Rf + β (Rm – Rf) so Rp = 7 + 0.68 (20 – 7) = 15.84%

A general rule for investors is to buy high beta shares in a bull market and in a bear
market to sell them and replace them with low beta shares.

theory into practice 8.3

A portfolio is made up of four investments, whose Answer
proportions in the portfolio and beta factors are Investment Proportion of Beta Proportion × Beta
as follows: portfolio
Investment Proportion of portfolio Beta A 0.20 1.6 0.32
A 0.20 1.6 B 0.25 1.2 0.30
B 0.25 1.2 C 0.40 0.8 0.32
C 0.40 0.8 D 0.15 1.8 0.27
D 0.15 1.8 Portfolio 1.00 1.21 1.21
Calculate the beta factor for the portfolio.
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 10:25 Page 142

142 COST OF CAPITAL AND CAPITAL STRUCTURE

test your knowledge 8.3

List the reasons for being cautious about using CAPM to calculate yields.

6 The arbitrage pricing model

The problems associated with the CAPM have led to the development of other
models, including the arbitrage pricing model (APM).
The CAPM is often criticised for its simplified relationship between risk and
return. The APM assumes that the return on a security is based on a number of inde-
pendent factors, and that the expected rate of return on a security is a function of the
risk premiums discussed below plus the risk-free rate. The model states that:
r = E(rj) + b1F1 + b2F2 + b3F3 + b4F4 + ….e
where:
E(rj) = the return expected from the security
b1 = the sensitivity to changes in factor 1
F1 = the difference between the expected and actual values of factor 1
b2 = the sensitivity to changes in factor 2
F2 = the difference between the expected and actual values of factor 2
b3 = the sensitivity to changes in factor 3
F3 = the difference between the expected and actual values of factor 3
b4 = the sensitivity to changes in factor 4
F4 = the difference between the expected and actual values of factor 4
e = a random term

To determine the factors to which returns on the securities are sensitive and which
form the basis of risk factors, factor analysis is undertaken. Key factors identified
include:
䡲 changes in the expected level of industrial production;
䡲 unanticipated changes in the term structure of interest rates;
䡲 unanticipated changes in inflation;
䡲 changes in the risk premium on bonds.
If it is expected that a certain combination of securities will produce higher returns
than indicated by the model, then arbitrage trading will occur with the aim of
improving expected returns. When no arbitrage opportunities remain, the expected
return on a security will be:
E(rj) = rf + b1(r1 2 rf) + b2(r2 2 rf) + b3(r3 2 rf) 1+ b4(r4 2 rf) + ……….
where:
rf = the risk-free rate
r1 = the expected return on a portfolio which has unit sensitivity to factor 1and
zero sensitivity to any other factor
r2 = the expected return on a portfolio which has unit sensitivity to factor 2 and
zero sensitivity to any other factor
r3 = the expected return on a portfolio which has unit sensitivity to factor 3 and
zero sensitivity to any other factor
r4 = the expected return on a portfolio which has unit sensitivity to factor 4 and
zero sensitivity to any other factor
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 15:27 Page 143

8 THE CAPITAL ASSET PRICING MODEL 143

The advantages of APM compared to CAPM are:

䡲 The need to determine the market portfolio is removed.
䡲 Systematic risk is broken into small components which need not be determined
initially.
䡲 APM explains the pricing of securities in relation to each other, as opposed to
CAPM which explains pricing in relation to the market as a whole.
The APM, however, does have disadvantages:
䡲 There is a need to identify those factors to which a security is sensitive.
䡲 The model is based on simplifying assumptions including portfolio theory and
perfect competition.
The APM, in common with CAPM, is a method of dealing with risk and return in
uncertain conditions. Empirical evidence has cast doubt on both models, without
disproving either. However, Hill (1995) states that CAPM is the model used in prac-
tice to determine the performance of portfolios, mainly because the APM has not yet
been fully developed.

test your knowledge 8.4

Why is the APM claimed to be superior to CAPM? Why is CAPM preferred in

practice?

chapter summary

䡲 The capital asset pricing model brings together aspects of valuation model which we considered earlier in
share valuation, the cost of capital and gearing and thus the course.
has important implications in financial management, 䡲 The model also implies equilibrium between risk and the
including: attempting to establish the ‘correct’ equilibrium expected return for each security and can be used by the
market value of a company’s shares; and calculating the financial manager in the assessment of risk in either
cost of a firm’s equity (and thus the weighted average cost individual company shares or that of a portfolio of
of capital), as an alternative approach to the dividend securities.

practice questions
Section A (4 marks each)
8.1 How can the CAPM help an investor choose which securities to have in an investment portfolio?
8.2
(a) Describe risk-free and excess returns.
(b) What is the difference between systematic and unsystematic risk?
8.3
(a) What does the beta factor of a share tell us?
(b) Calculate the return on a particular share with a beta factor of 0.7, given the following data:
Return on government securities: 6.5%
Market return: 9%
What would happen if market return:
(i) Increased to 12 per cent?
(ii) Fell to 5 per cent?
8.4 How can the failure of a company’s auditors to do their job properly affect the company’s cost of capital?
8.5 What is the Capital Market Line?
C08_ST_CORP_FIN_MAN_9781860724237.QXD:ICSA 17/6/09 15:27 Page 144

144 COST OF CAPITAL AND CAPITAL STRUCTURE

8.6 A company’s shares have a beta value of 0.8; the risk-free return on an investment in UK government stock is 5.0%; the
market return is 15%. Calculate the expected return on the company’s shares using the capital asset pricing model.
Explain what is meant by a rational investor in connection with the Capital Asset
Pricing Model. How does the model show what needs to be done to meet the requirements of such an investor?

Section B (20 marks each)

8.8 How realistic is the CAPM, and can it be used to determine the price of shares?
8.9 You have recently been appointed company secretary to Spider plc and have been asked by the managing director to
estimate the company’s weighted average cost of capital. You have ascertained the following information:
(a) The company is financed by 50 million £1 shares with a market price of £1.20 and reserves and share premium
accounts totalling £100 million.
(b) A dividend of 2.25 p per share has just been paid, an increase of 20 per cent on the previous year (this is the normal
annual increase in dividends for the company).
(c) The rate of corporation tax is 30 per cent.
(d) The company’s shares have a beta of 1.6.
(e) The return on government stocks is 4.5 per cent and the return on the market is 14 per cent.
(f) In addition to share capital the company has £20 million (at market value) debt in its capital structure at a pre-tax cost of
12 per cent.
The managing director has recently read that there are different methods available for calculating the cost of equity and
is particularly interested that you calculate the overall cost of capital using the dividend valuation model first and the
capital asset pricing model second.
Prepare a report providing the managing director with the figures he requires, explaining any resulting differences.