University of Phoenix Online
Introduction to Finance and Accounting
James R. Sullivan
November 3, 2008
An established company is considering expanding its operations, and to achieve their business objectives, the company will require additional long-term capital financing. Long-term financing involves debt or equity instruments with greater than one-year maturities, and the cost of this long-term capital can be calculated using either the Capital Asset Pricing (CAPM) or Discounted Cash Flows (DCFM) Model. The organization will have to compare and contrast the Capital Asset Pricing Model with the Discounted Cash Flows Model. The skill of comparing and contrasting financial options will help evaluate and organize the debt/equity mix and dividend policy. The organization must then decide what type of long-term finance alternatives will most likely benefit. Capital Asset Pricing Model and the Discounted Cash Flows Model Capital Asset Pricing Model is a linear relationship between returns on individual stocks and stock market returns over time (Block & Hirt, 2005). One use of CAPM is to analyze the performance of mutual funds and other portfolios (CAPM, 2008). Although, more than one formula exists for the CAPM, the most common is referred to as the market risk premium model presented below (Block & Hirt, 2005): r = Rf + beta (Km – Rf)
Where: r is the expected return rate on a security Rf = the risk free rate of return (cash)
B = beta coefficient, or historical volatility of common stock relative to market index Km = is the return rate of the appropriate asset class The market risk premium formula assumes that the rate of return or premium demanded by investors is directly proportional to the perceived risk associated with the common stock. Beta measures the volatility of the security relative to the asset class. The equation is saying that investors require higher levels of expected returns to compensate them for higher expected risk. This formula can be thought as predicting a security’s behavior as a function of beta: CAPM says that if a person knows a security’s beta then they know the value of (r) that investors expect it to have (see graph below) (CAPM, 2008). [pic]
More volatile stocks will have a beta coefficient greater than 1.0, whereas less volatile stocks will have a beta less than 1.0. If the risk free rate of return (Rf) and average market return (Km) are considered fixed, then the required rate of return for company stock can be calculated for the required rate of return. As an example, if the market risk premium (Km – Rf) is 6% and a risk free rate of return (Rf) is 4%, then the required rate of return would equal 10% for B = 1 and 16% for B = 2. The Discounted Cash Flow Model (DCFM) is another standard way of determining the cost of equity. It assumes that a firm’s current stock price is equal to the present (discounted) value of all expected future dividends from the investment (Utility Regulation, 2008). Modern financial theory contends that the price of a firm’s stock is the present value of the future cash flows discounted at an appropriate interest rate (Freeman & Gagne, 1992). To calculate the current stock value, calculate the present value of future dividends and growth in the value of the stock at some future date. The discount rate used for this present value calculation is the weighted average cost of capital for the firm. Both the CAPM and DCF models involve applying data from a single or group of companies, to evaluate the current stock value of a single company. CAPM is more objective and complicated, and requires more calculation and data from the market. DCF is more subjective and simplified. One such DCF assumption is that future dividends...