Q.1 (1.5 pages)Our discussion topic concerns the calculation of stock values using the capital asset pricing model (CAPM). Explain the CAPM model. The textbook provides a list of betas for a selection of stocks. Choose two firms from that list and discuss whether the betas are what you would expect. Be sure to explain why or why not. Calculate the returns based on the CAPM model. Be sure to state your assumptions.
Q.2 Write a reply for this discussion (for Mari) 200 words is fine for this reply
Explain the CAPM model.
CAPM stands for Capital Asset Pricing Model.
It helps us to compute the cost of the asset (particularly equity) by assigning value to the risk component in it.
An investor typically invests in an equity to get a return which is more than the time value of money. Hence to arrive at the cost which factors both time value of money and compensation for the risk factor, CAPM is used.
Formula for CAPM
Expected Return of Investment = Risk free rate of Return + Beta * (Market Rate of Return – Risk Free Rate)
Here risk-free rate of return compensates the investor for the time value of money.
Beta compensates the investor for the risk. Hence beta is applied on the return which is above risk-free rate of return. Higher the risk investment carries, higher is the beta and consequently higher return on investment.
Advantages of CAPM
1. Simple to calculate the cost of investment
2. Widely used for financial calculations and calculating Weighted Average cost of capital
Disadvantages of CAPM
1. Beta never reflects the true risk in the stock and hence this may lead to inaccuracies
2. It assumes a constant risk-free rate for calculations, which is never a reality.
Understanding the Capital Asset Pricing Model (CAPM)
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf + βi (ERm − Rf) where: ERi = expected return of investment Rf = risk-free rate βi = beta of the investment (ERm − Rf) = market risk premium ERi = Rf + βi (ERm − Rf) where: ERi = expected return of investment Rf = risk-free rate βi = beta of the investment (ERm − Rf) = market risk premium
WACC for a Real Firm
Weighted average cost of capital (Links to an external site.) (WACC) is used by analysts and investors to assess an investor’s returns on an investment in a company. As most businesses run on borrowed funds, the cost of capital becomes an important parameter in assessing a firm’s potential for net profitability. WACC measures a company’s cost to borrow money, where the WACC formula uses both the company’s debt and equity in its calculation.
• The weighted average cost of capital (WACC) is a calculation of a firm’s cost of capital in which each category of capital is proportionately weighted.
• All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation.
• WACC is calculated by multiplying the cost of each capital source (debt and equity) by its relevant weight by market value, and then adding the products together to determine the total.
• The cost of equity can be found using the capital asset pricing model (CAPM).
• WACC is used by investors to determine whether an investment is worthwhile, while company management tends to use WACC when determining whether a project is worth pursuing.
The Formula for WACC
The WACC formula includes the weighted average cost of equity plus the weighted average cost of debt. Note that, generally, the cost of debt (Links to an external site.) is lower than the cost of equity given that interest expenses are tax-deductible.
WACC= (EV × Re) + (DV × Rd × (1− Tc)) where: E = Market value of the firm’s equity D = Market value of the firm’s debtcV =E + DRe = Cost of equity Rd = Cost of debt Tc = Corporate tax rate WACC = (VE × Re) + (VD × Rd × (1− Tc)) where: E = Market value of the firm’s equity D = Market value of the firm’s debt V = E + DRe = Cost of equity Rd = Cost of debt Tc = Corporate tax rate
How to Calculate WACC
WACC formula is the summation of two terms:
(EV × Re)(VE × Re) (DV × Rd × (1− Tc)) (VD × Rd × (1−Tc))
The former represents the weighted value of equity-linked capital, while the latter represents the weighted value of debt-linked capital.
https://www.investopedia.com/terms/c/capm.asp (Links to an external site.)
https://www.investopedia.com/ask/answers/063014/what-formula-calculating-weighted-average-cost-capital-wacc.asp
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Question 1: (1.5 pages) The capital asset pricing model is used to calculate stock values, which is the subject of our discussion (CAPM). Describe the CAPM model in detail. A list of betas for a variety of equities is provided in the textbook. Select two companies from the list and discuss whether the betas are as expected. Make careful to explain why you’re doing it or why you’re not doing it. Using the CAPM model, calculate the returns. Make a point of stating your assumptions.
Q.2 Respond to this topic by writing a response (for Mari) 200 words is fine for this reply
Explain the CAPM model.
CAPM stands for Capital Asset Pricing Model.
It helps us to compute the cost of the asset (particularly equity) by assigning value to the risk component in it.
An investor typically invests in
