The Capital Asset Pricing Model (CAPM) is one method of determining a cost of equity based on the risks faced by
shareholders. As such it can be viewed as part of a wider discussion looking at cost of capital.
secured lenders
legally-protected creditors such as tax authorities
unsecured creditors
preference shareholders
ordinary shareholders.
As their earnings also fluctuate, equity shareholders therefore face the greatest risk of all investors. Since ordinary
shares are the most risky investments the company offer, they are also the most expensive form of finance for the
company.
The level of risk faced by the equity investor depends on:
Given the link to the volatility of company earnings, it is these investors that will face more risk if the company was to
embark on riskier projects.
If we want to assess the impact of any potential increase (or decrease) in risk on our estimate of the cost of finance,
we must focus on the impact on the cost of equity.
The return required by equity investors can be shown as
In the diagram above, the investor has combined investment A (for example shares in a company making
sunglasses) with investment B,(perhaps shares in a company making raincoats). The fortunes of both firms are
affected by the weather, but whilst A benefits from the sunshine, B loses out and vice versa for the rain. Our investor
has therefore smoother overall returns - i.e. faces less overall volatility / risk and will need a lower overall return.
The returns from the investments shown are negatively correlated - that is they move in opposite directions. In fact
they appear to have close to perfect negative correlation - any increase in one is almost exactly matched by a
decrease the other.
The diagram above is an exaggeration, as it is unlikely that the returns of any two businesses would move in such
opposing directions,but the principle of an investor diversifying a portfolio of holdings to reduce the risk faced is a
good one.
However an investor can reduce risk by diversifying to hold a portfolio of shareholdings, since shares in different
industries will at least to some degree offer differing returns profiles over time.
Provided the returns on the shares are not perfectly positively correlated (that is they do not move in exactly the same
way) then any additional investment brought into a portfolio (subject to a maximum point - see below) will reduce the
overall risk faced.
Initial diversification will bring about substantial risk reduction as additional investments are added to the portfolio.
The risk a shareholder faces is in large part due to the volatility ofthe company's earnings. This volatility can occur
because of:
systematic risk - market wide factors such as the state of the economy
non-systematic risk - company/industry specific factors.
Systematic risk will affect all companies in the same way (although to varying degrees). Non-systematic risk factors
will impact each firm differently, depending on their circumstances.
Diversification can almost eliminate unsystematic risk, but since all investments are affected by macro-economic
i.e.systematic factors, the systematic risk of the portfolio remains.
arrange their portfolios to maximise risk reduction by holding at least 15-20 different investments
effectively eliminate any unsystematic risk
only need to be compensated for the remaining systematic risk they faced.
Understanding beta:
If an investment is riskier than average (i.e. the returns more volatile than the average market returns) then > 1.
If an investment is less risky than average (i.e. the returns less volatile than the average market returns) then < 1.
If an investment is risk free then = 0.
those companies paying above average returns are assumed to have a correspondingly higher than
average systematic risk and their beta (the measure of the company's systematic risk compared to the
market) is extrapolated accordingly
the extrapolated beta is then considered a measure of the risk of that business area.
However, the above only considers the business risk. When using betas in project appraisal, the impact of financial
gearing (hereafter referred to as "gearing") must also be borne in mind.
both are identical in all respects including their business operations but
However, in many exams, d will be assumed to be zero. This means that the asset beta formula can be simplified to:
where:
Ve = market value of equity
Vd = market value of debt
T = corporation tax rate.
When using this formula to de-gear a given equity beta, Ve and Vd should relate to the company or industry from
which the equity beta has been taken.
If using the adjusted present value (APV) approach, then this asset beta can be used to calculate a Ke to determine
the base case NPV.
If needing a risk adjusted WACC, then the following steps need to be followed as well.
Note: for a discussion of which approach to use when, please click here.
(2)Adjust the asset beta to reflect the gearing levels of the company making the investment
Re-gear the asset beta to convert it to an equity beta based on the gearing levels of the company undertaking the
project. The same asset beta formula as given above can be used, except this time V e and Vd will relate to the
company making the investment.
(3)Use the re-geared beta to find Ke. This is done using the standard CAPM formula.
Remember that CAPM just gives you a risk-adjusted Ke, so once a company has found the relevant shareholders'
required return for the project it could combine it with the cost of debt to calculate a risk adjusted weighted average
cost of capital. This is discussed in further detail here