Capital Budgeting Techniques And Pricing Assessment Answer

The CAPM is given as follows:

Ri = Rf + {E(Rm-Rf)}

Ri- required rate of return of security i

Rf = risk-free rate of return

E(Rm) – expected market rate of return

β – beta that is calculated as follows:

β= Cov (im)

σ²m

Cov(im)- Covariance between the rates of return in the market together with the asset.

σ²m – covariance of the market return

2. Explain the relationship between the Security Market Line and the Capital Market Line, using diagrams and examples to illustrate your explanation

When β and E(Ri) are graphed, the following relationship can be observed;

 

                                                                        E(Ri)

All correctly priced asset will lie on the security market line. Any security off the line will either be overpriced or underpriced. According to Pinches &George (1996), the security market line, for this reason, shows the pricing of all asset if the market is relatively constant. If the investor was to undertake a given level of risk, he or she would expect the rate of return present in the market.

3. Briefly set out arguments in favor of – and against - the theory, outline its uses and make a critique of its underlying assumptions.

• CAPM is a single period model, and it looks at the end of the year returns.
• CAPM is not quantifiable since the investor’s expectations cannot be measured.
• CAPM assumes that the required rate of return relies on the beta in the stock market.

However, other factors such as inflation sensitivity and dividend payment have an impact on the return of the security (Scott &David 1999)

3.1. Limitation of CAPM

Though CAPM is widely applicable to many states, it has some several fatal weaknesses which include:

CAPM is founded on some asssumption which are actually not realistic.

1. They include:Existence of the risk-free asset.

2. All property being perfectly divisible and marketable (human capital is not distinct.

Existence of homogenous expectations about the expected returns.

1. Asset returns are spread out over a normal distribution.

2. No taxes. Ideally, there is no way a country can survive without taxes since taxes are the main source of government revenue (Pike, 1996).

3. No commissions. CAPM postulates that commissions are non-existent and do not count and hence should be done with. According to Petry & Glenn (1975), this is not true in the real world since the central bank as well as other financial institutions render commissions thus disregarding the model.

4. Conclude with an overall assessment of the theory and state any recommendations you may have for your study.

If CAPM was to be used, that would mean that the market would be central institution where investors make all their investments (Klammer 1972). This is also to validate the point that there should be uniform expectations by investors in the same market.

Additionaly, the risk premium existing in the market can be seen to be subject to systemic risk which is measured by covariance with the market.

CAPM provides for risks and it acknowledges that the value of assests in the security market are prone to variations brought about by risks. Hence the return amount of each asset is an estimate which is the expected return based on past returns (Levy, Haim & Marshall 1994)

CAPM model believes in the existence of equilibrium in the market prices and returns. However, these factors are dictated by the economic behavior of each individual which is generally deemed to be rational.

5. Conclusion – a brief overall assessment of the CAPM theory.

The CAPM is by no means a perfect model. The model is not applicable in the modern economies which are characterized by massive fluctuations brought about by recessions and depressions over the economic regimes. Emery, Douglas, & John (1998) postulated that the assumptions forwarded by the theory compromise with the conditions of the market in the modern world. Other models such as APT are hence preferred as they are more flexible, reliable and convenient to use in evaluating asset returns.

6. Identify any alternatives that have been suggested in place of CAPM in a place of CAPM, Arbitrage pricing theory may be used.

 APT (Arbitrage pricing theory)

This theory was developed in order to overcome several weaknesses associated with CAPM.

Ross (1976) formulated APT. APT offered a testable alternative to the capital pricing model. Disparities between CAPM and APT occur at the instant CAPM provides for lineality of returns which are dependent on the rate of return (Fremgen, James 1973). APT however, is also based on the theory that business activities are general and that at equilibrium, the return on abitrage portfolio is zero. That implies that the investments posses a zero systemic risk. Incase the payoffs are postive, then, the risk would eliminated by the arbitrage process which would inturn would add value to the payoffs (Anderson, 1972). In 1976, Ross illustrated that when the opportunity of arbitrage was no longer present, the return amount to expect would be given by:

E(Ri) = Rf + β1(Ri-Rf) + β2(R2-Rf)+ ……….. βn(Rn-Rf) + ϵi

Where:

E(Ri) – expected return on the security

Rf – Risk free rate

β1 – Sensitivity to changes in factor i

ϵi – random error term

Arbitrate pricing theory Limitations . Though APT model is efficient, it does not highlight the relevant factors to include in the list of elements that affect the investment yields. Nevertheless, it does not indicate the number of factos to take into place when considering the model. However, the most important factors include, inflation, industrial production, spread between low and high- grade bonds as well as the rate of interests included in the loan period regime (Ahadiat & Brueggemann 1990).

Comparison between APT with CAPM

1. APT is a more powerful model than the CAPM due to some factors such as:

2. APT does not make any assumptions regarding the spread of asset returns while CAPM assumes a normal

3. The APT makes no strong assumption about individual’s utility functions. According to Gordon & Natarajan 2007), the theory is based on investors who are generally risk averters)

4. The APT allows the equilibrium return to rely on myriad factors rather than only the market β.

5. Testing the whole wide collection of assets is not mandatory since the theory is not a must as one can collect only a few samples and obtain the relative prices.

6. APT provides no special requirement in the market unlike CAPM requires that the market portfolio be efficient.

7. The APT is easily extended to a multi- period framework.

However, APT models fails to outline the factors which should be put into consideration. Cho (1984) indicated that the returns of securities vary in accorandance to several factors. These factors include: inflation, expected variations in industrial production, risk premium changes in bonds as well as the abrupt fluctuations in the interest rates (Brealey, Richard & Stewart 1997).

PART 2 – Capital Budgeting Analysis

You are required to work the following problem, using a discounted cash flow (NPV) analysis. You should model your answer on the text approach in Chapter 8.

“Gordon Hall is considering replacing an old machine with a new one from Li Ho. The old machine (bought five years ago from Tom Lee) cost $340,000 while the new one will cost $280,000, fully financed by a five year 9% per annum interest only loan.

“The new machine will be depreciated prime cost to $50,000 over its 5-year life. Gordon estimates that it will be worth $40,000 (salvage value) after five years. The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, George can sell the old machine today for $86,000. “The new machine will save Gordon $70,000 a year in cooling costs. Other costs are that, one year ago, a feasibility study on the new machine conducted for Gordon by an external firm of consultants, cost Gordon $20,000. With the new machine, Gordon will also lose $10,000 of sales of another product to Tom Lee. “With the new machine, a one-off amount of cleaning supplies (current assets) at a cost of $9,000 will be required, and Henry estimates that accounts receivable   (also current assets) will increase by $14,000. Both of these increases in working capital will be recouped at the end of the new machine’s life in five years time “Gordon’s cost of capital is 9%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

Required.

Calculate the net present value of the proposed change, that is, the net benefit or net loss in present value terms of the proposed changeover.

Year                            0               1               2             3                  4               5

Annual Savings                     70,000         70,000     70,000          70,000     70,000

Less

Depreciation                            50,000         50,000         50,000       50,000       50,000

Taxable Income                       20,000         20,000         20,000        20,000       20,000

Tax (30%)                               6,000               6,000               6,000     6,000         6,000

Operating Cash flows             64,000           64,000         64,000         64,000       64,000

∆ Net working capital 23,000                                                                             -23,000

Investment                  - 280,000                                                                              40,000

Total cash flows          -257,000   64,000       64,000       64,000           64,000     81,000

 

PV C₀                                =                          - 257,000

PV C₁ =   64,000/ (1.09)¹ = 58,715.60

PV C₂ =   64,000/ (1.09)² = 53,867.52

PV C₃ =   64,000/ (1.09)³ = 49,419.74

PV C₄ =   64,000/ (1.09)⁴ = 45,339.21

PV C₅ =   81,000/(1.09)⁵    = 52,644.44

Total PV =                                                     259,986.51     

Total NPV                                                         2,986.51

 

 Should Henry purchase the new machine? State clearly why.”

Henry should purchase the new machine since it generates positive cash flows and hence it stands to benefit him.

 

References

Ahadiat, N. & Brueggemann. R. (1990). Evaluating an investment proposal. Journal of Accounting Education. 8 (2), 299-310

Anderson, C. M. Jr. (1972). The capital budgeting process. London: n.p. 30-32

Brealey, Richard, A. & Stewart A. M. (1997). Principles of Corporate Finance. 5th ed. New York: McGraw-Hill Companies.

Fremgen & James M., (1973) “Capital Budgeting Practices: A Survey,” Management Accounting.

Emery, Douglas, R., John, D., & John, D. S. (1998). Principles of Financial Management. Upper Saddle River, NJ: Prentice Hall. 19-25

Klammer, T. (1972). Empirical Evidence of the Adoption of Sophisticated Capital Budgeting Techniques,” The Journal of Business 45 (No. 3, July), 387-397

Levy, Haim & Marshall S. (1994). Capital Investment and Financial Decisions. 5th ed. New York: Prentice Hall.

Pike, R. (1996). “A Longitudinal Survey on Capital Budgeting Practices,” Journal of Business Finance and Accounting. 23 (1), 79-92.

Petry, Glenn H. (1975). “Effective Use of Capital Budgeting Tools,” Business Horizons 5 (October), 57-65

Pinches, T., & George E. (1996). Essentials of Financial Management. 5th ed. New York: HarperCollins.

Schall, R., Lawrence, D., Gary, L. &William, R. (1978). Survey and Analysis of Capital Budgeting Methods. Journal of Finance 33 (1), 281-288.

Scott, David F., Jr., (1999). Basic Financial Management. Upper Saddle River, NJ: Prentice Hall.