CAPM and Sources for Capital

Introduction

A specific risk is one that is linked with individual asset. These risks can be minimized within a portfolio through diversification. Besides, “specific risk is also called unique or diversifiable risks” (Benninga, 2008). A portfolio risk, also known as market risk, is one that is general to all the securities. Nonetheless, it is not possible to diversify undiversifiable risk within one market. It is necessary to note that a specific risk can be expanded. This takes place within a given market-portfolio. Therefore, “undiversifiable risk is equated to the standard deviation of the market portfolio” (Veronesi, 2010). Asset pricing can also be done through conditional models. Undiversifiable risks are controlled by the long and short mechanisms, which are present in a single market portfolio. Thus, they develop a portfolio that is market neutral.

On the contrary, an asset that is diversifiable risk free can be regarded as a hypothetical one, because it pays a rate that is risk free. For instance, short securities such as treasury bills can act as risk free assets. The reason for this is that the securities are able to pay a certain rate of interest that is fixed, and they usually have a low default risk. An asset that is risk free has a zero variance, and this makes it to be risk free. In addition, an asset that is risk free is also not correlated to other assets, because of its zero variance components. Moreover, a systematic risk is one that is linked to a specific asset. These risks can be minimized within a portfolio through diversification (Veronesi, 2010).

A substantial unexpected increase in inflation is systematic risk, because it can be linked to the market factors, which affect the entire firm/industry. In addition, it is not removed by diversification of the investor’s portfolio (Benninga, 2008).

Diversification can also enable the investor to gain the expected return on portfolio, but with a minimum risk. Indeed, the assets that have high yields present more risks than the ones with lower returns. Modern portfolio theory also provides guidelines for choosing low risk portfolios. Therefore, modern portfolio theory is a type of diversification (Benninga, 2008).

A major recession in the United States falls under the undivesifiable possibility, because it affects several sectors of the economy, market and different firms/industries. The recession is not linked to one firm alone, but it affects several companies. Therefore, it is not possible for an investor to diversify this kind of risk.

A major lawsuit is filed against one large publicly traded corporation is a diversifiable risk, because it affects a single firm/industry. The diversifiable risk can be eliminated when an investor diversify his/her portfolio. Even though, this kind of threat can be avoided, losses suffered by investors are not always compensated by the market (Veronesi, 2010).

Using the Capital Asset Pricing Model (CAPM), the Expected Rate of Return on the Market

E (R_i) = 4% + 1.2 (Rm – 0.04)

0.12 = 0.04 – 0.048 + 1.2 Rm

Rm = 0.106667

Therefore, Expected Rate of Return on the Market Portfolio = 10.67%

Using the Capital Pricing Model (CAPM) formula, the Risk Free Rate can be calculated as shown below.

Rate of return on Asset (Ra) = Risk Free Rate (Rf) + Beta (β) * [Expected Return on            Market Portfolio (Rm) - Risk Free Rate (Rf)]

9%=Rf+ [0.8(10%-Rf)]

0.09 = Rf + 0.8 (0.1 –Rf)

0.2 Rf = 0.01

Rf = 0.05

Therefore, the Risk-Free Rate (Rf) = 5%

Beta will increase by the same magnitude, because it has a linear association with the stock portfolio returns. Beta shows a relationship between the daily returns of the market and the daily returns on share prices. Therefore, if one owns half of the traded stocks, it is probable that the average beta of the portfolio will be almost the same as the whole of the stocks’ beta (Veronesi, 2010). It is evident that larger stock portfolio often provides beta that is almost approaching one.

The main message of the Capital Asset Pricing Model (CAPM) to corporations is that it is necessary for determining the relationship between financial returns and risk. This can be analyzed under the Capital Asset Pricing Model (CAPM) and Security Market Line (SML).

It is evident that the “Security Market Line (SML), indicated in this graph, describes a relationship between the beta and the asset's expected rate of return” (Koller & Wessels, 2010). It also illustrates the expected financial return and risk of an investment.

The symbol beta (β) refers to the quantification of the sensitivity of an asset to the changes in the whole market (Benninga, 2008). Beta can be found by the regression of the past data.  

The above formula shows that a risk premium can be equated to a market-premium. The result is multiplied by the beta (β).  Under CAPM, the application of beta is explored. The concept of beta can also be used in calculating Weighted Average Cost of Capital (WACC), which has been illustrated by the following formula.

Illustration

Suppose Corporation X has 1749 million common shares with the value of $ 0.01 per share, and then this translated to $17.49 million. A debt has face value of $ 8.999 million and it is currently trading in the market at 100% of face, $ 8.999 million.  Total market value of both equity and debt =$26.489 million. 

Equity % = 100%

Debt % = 0.00001%

Risk free rate is 2.7%

Risk premium=32% 

X’s β= 1.45%.

Return on equity per SML: RE = 2.7% + (32% x 0.0145) = 3.16%

Tax rate = 40%

WACC = (E/V) x RE + (D/V) x RD x (1-Tc)   

             = 1 x 0.1163 + (0.0 x 0.027 x 0 .60)      

             = 0.1163 or 11.63%                

CAPM’s main message to the investors is that returns and risks have positive correlation (Benninga, 2008). This implies that individual stock is positive to a market portfolio, and investors should diversify their investments.

It was necessary for American Superconductor (AMSC) to forgo debt financing and choose equity financing. Equity financing is advantageous, because the funds are committed to the business and its projects. Investors can only realize returns when the company is performing well. The realization is often achieved when new stock is floated in the market or when the business is sold to new investors. Moreover, there are no costs involved for debt finance services and bank loans. This implies that the capital raised can be used for company’s operations at no cost (Veronesi, 2010). Investors, who have contributed capital to the company, always expect the corporation to perform well, and this makes the management team to come up with strategic growth plans. In certain situations, the investors are capitalists who have wide knowledge and experience in business, thus they can bring invaluable expertise, skills and experience to the company. Such important skills are necessary for strategic decision-making processes. Besides, the investors will be ready to monitor and provide more funding to the company (Koller & Wessels, 2010).

Even though, equity financing has many advantages, it suffers certain limitations. The process of equity financing is tedious and procedural, because legal and regulatory procedures must be complied with, before the process of raising capital begins (Koller & Wessels, 2010). This type of financing consumes a lot of time and valuable resources of the company. Moreover, it implies that the company’s attention on its daily business operations can be easily diverted to other activities. At the initial stages of financing, only limited amounts of funds can be realized. In addition, outside investors may take control of the company, especially when they have more shares allocated to them.

Following the argument above, it is an appropriate decision for the American Superconductor to opt for the equity financing, instead of the debt financing. Debt financing suffers the limitation of higher interest charges/costs of borrowing. In this regard, the company can choose to issue stocks instead of bonds since the latter are loans paid back with interests. In addition, the bonds are repaid in full amount with interest (Veronesi, 2010).

The cost of equity can also be calculated by the Capital Asset Pricing Model (CAPM).

Cost of equity (Ke) = Risk free rate of return (Rf) + Beta (β) x [market rate of return (Rm)- risk free rate of return (Rf)]           

In sum, there is a tax deduction from a debt financing, because its calculation incorporates a corporation tax component (Benninga, 2008). This can be illustrated by the formula shown below.

Cost of debt = (Rf + credit risk rate) * (1-T)

Where: T = corporate tax rate

            Rf = Risk free rate