Module 3 SLP
FIN301: Principles of Finance
August 31, 2011
Starbuck’s CAPM and Sources for Capital
By definition beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Beta is used in the capital asset pricing model (CAPM), a model that calculates the expected return of an asset based on its beta and expected market returns (Investopedia, 2011). According to Wikipedia (2011), in finance, CAPM is used to determine a theoretically appropriate required rate of return of an asset, if that asset is to be added to an already well-diversified portfolio, given that asset's non-diversifiable risk. The model takes into account the asset's sensitivity to non-diversifiable risk (also known as systematic risk or market risk), often represented by the quantity beta (β) in the financial industry, as well as the expected return of the market and the expected return of a theoretical risk-free asset. This session long project will analyze Starbuck’s CAPM and sources for capital.
Using Yahoo Finance, it shows that Starbuck’s estimated beta coefficient is at 1.26 percent: (Ra-Rf)/ (Rm-Rf) = Beta. Starbucks “Beta” coefficient is a measure of the stock’s volatility in relation to the rest of the market. The Beta is calculated for individual companies using regression analysis. The beta coefficient is a key parameter in the CAPM. It measures the part of the asset’s statistical variance that cannot be mitigated by the diversification provided by the portfolio of many risky assets, because it is correlated with the return of the other assets that are in the portfolio (Yahoo Finance, 2011). In order to be successful, an investor must understand and be comfortable with taking risks. Creating wealth is the object of making investments, and risk is the energy that in the long run drives investment returns. My answer to that is “Beta” may seem to be a good measure of risk; there are some problems with relying on beta scores alone for determining the risk of an investment. Beta looks backward and history is not always an accurate predictor of the future. Beta also doesn’t account for changes that are in the works, such as new lines of business or industry shifts. Beta suggests a stock’s price volatility relative to the whole market, but that volatility can be upward as well as downward movement. In a sustained advancing market, a stock that is outperforming the whole market would have a beta greater than 1.
We find the present 'cost of equity' of Starbucks by using the CAPM Equation. Ke = Rf + (Rm-Rf) X beta where Rf is the risk free rate = 4.5% (Rm-Rf) = market risk premium = 6.5% beta = 1.26 Cost of equity = 4.5% + 6.5% X 1.26 = 13.8% (Wikipedia, 2011). The 'cost of equity' means that if Starbuck’s has a 13.8% cost of equity, or required return, then I need to earn at least 13.8% on my investment in order to “break even”, or compensate me for the risk I took, with what my rate of return vs. risk would have been by investing this money in a risk free investment (Investorwords, 2011).
In choosing two other companies, and looking up their "Beta". Coca-Cola which has a .57 beta, McDonald’s which has a .36 beta and my company has 1.26 beta. I’m investing one third of my money in each of the stocks of these companies. The beta of the portfolio in this case the weight of each is 1/3. Portfolio beta = 1/3 X .57 + 1/3 X .36 + 1/3 X 1.26= .19+.12+.41 = .72 beta (Yahoo Finance, 2011). My three stock portfolios are not sufficiently diversified. For risk to be sufficiently diversified the portfolio should have a 1 to 1.5 stocks. The stocks should be from all sectors of the economy and not concentrated in specific sectors. In my portfolio: Starbucks, Coca-Cola, and McDonald’s belong to the same sector and so that would not help in diversification. What I need to do is divide the economy in...