Business Finance- Final Assessment
Naturally Fresh Plc
A report to the directors of Naturally Fresh Plc evaluating the financial position of a new project. The proposal concerns converting a number of farms in southern Europe into camp sites with effect from the 2012 holiday season.
Section 1: The required rate of return on equity of naturally Fresh Plc at 31st December 2012
The rate of return on equity represents the percentage return a company needs to achieve to be worth investing in. Using the Capital Asset Pricing Model (CAPM), as it’s the most widely used and best known model of risk and return, we can determine the required rate of return on equity of Naturally Fresh Plc. The basic principle of CAPM is to compensate investors by considering the risk and time value of money. It represents this by incorporating the following factors: 1. A risk- free rate(rf)
2. A beta(β)
3. Expected market return(rm)
These components then make up a formula, which is used to calculate the cost of capital, or return(r) on an investment. The formula is: r = rf + β (rm – rf)
The time value of the money is shown by the risk-free rate. This compensates the investors for placing money in any investment over a length of time. The latter half of the formula portrays the risk and computes the amount of compensation the investor requires for taking an additional risk. In the case of Naturally Fresh Plc, the information provided from the company’s finance structure gives us a return rate of 10% (Appendix 1) This rate of return means that if Naturally Fresh Plc wants to undertake any new projects or invest in new stock or securities, they’ll need to meet or beat a return of 10%. That way they will ensure it is an economically viable and worthwhile investment.
Section 2 :Implications of a beta less than 1 and the impact to Naturally Fresh Plc of a 5% increase or decrease on market returns.
The Beta coefficient measures the sensitivity of securities to market movement. All shares average out to a beta value of 1; therefore a beta of 1 indicates that the security’s price will move with the market. A beta of greater than 1 will imply the security’s price will be more volatile than the market. For example, if a company’s beta is 1.3, it’s theoretically 30% more volatile than the market, therefore resulting in a greater reward. A beta of less than 1 will indicate the security’s price will be less volatile than the market. Naturally Fresh has a Beta of 0.8. This implies that during market movements upwards and downwards, Naturally Fresh Plc will increase and decrease slower than the market. This is shown in the calculations in (Appendix 2) The required rate of return determined by CAPM earlier provided a market based measure of the return shareholders require for investing in the company. This cost of equity capital provides a level that shareholders can use to evaluate whether they are achieving the most value from their investment. Due to the fact the beta coefficient is less than 1, shareholders know that as the market return increases or decreases, the company’s rate of return is less volatile and therefore less risky. The shareholders can find comfort in that.
Section 3: The Capital Asset Pricing Model (CAPM), the Arbitrage Pricing Theory (APT) and the Three Factor Model The limitations of CAPM are:
* The expected return cannot be measured only the actual return * It’s a single period
* The beta must remain stable overtime
* It assumes that the risk can be summarized in a single figure * It is difficult to test the validity of CAPM
* CAPM appears to overestimate the returns on small capitalisation companies. * The discount rate may not be appropriate for a ‘whole life’ project.
Arbitrage pricing theory does not clearly state the relevant macroeconomic factors, it has been observed that the following factors tend to...
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