Limitation Of Capital Asset Pricing Model Essay

Question:

Discuss about the Limitation of Capital Asset Pricing Model.

Answer:

Introduction

Capital budgeting is a process which helps a business in determining the amount that should be invested in a project and the desired return for that particular project. This enables the managers use capital majorly long term funds that will help the organization to generate more cash flows for certainly some future years. It is one the most challenging task for managers because it outlays the investment decision, and organization’s major funds are locked into this decision. It enables a company to focus on its long term goals. There are various methods under capital budgeting like modified internal rate of return (MIRR), average accounting return (ARR), accounting rate of return, profitability index (PI), payback period, net present value (NPV), and internal rate of return (IRR). These all methods are considered as relevant in capital budgeting because actual results were not matching with expected results.

In capital budgeting methods which are used for risk analysis are break even analysis, hillers’ model, simulation analysis, sensitivity analysis, scenario analysis, decision tree analysis. Following some of the methods are discussed.

Sensitivity analysis:

According to Saltelli, 2004, the study in which how much the amount of uncertainty in the output of a model(numerical or otherwise) can be allocated to different sources of uncertainty in the model input, that is why it is known as the “what if analysis’(Lumby & Jones,2007).

Sensitivity analysis estimates about degree to which various estimates about a project can change before the decision advised by NPV is overturned. There are two major advantage of this. The first advantage is that an investor is able to get clear that which decision advice is more sensitive. Hence he is able to take more time to make accurate decisions as possible. The second advantage is that it gives more information to the investor that whether to rely upon the decision made by NPV analysis or not.

There are two major disadvantages in sensitivity analysis. The first disadvantage is it takes only one estimate at a time that is it does not consider the simultaneous change in two or more estimates. The second disadvantage is that it gives no indication that how the investor would make the use and evaluate the decisions of sensitivity data.

In addition, if cost of management like fixed cost, variable costs, and investment costs rises above the expectation. Sensitivity analysis treats each variable as separate when, different variables are likely to be related to each other.

Hence it can be said that a sensitivity analysis is a method which enables the investor to know, the different values of exogenous variable can affect the value of endogenous variables.( Ratto, Campolongo, Gatelli, Tarantola; 2008)

Sensitivity analysis in relation with capital budgeting:

Capital budgeting is a process which helps a business in determining the amount should be invested in a project and the desired return for that particular project. In sensitivity analysis we change one input variable at a time and examine the effect on the output variables. The sensitivity analysis guides the business for making investment decision effectively and in estimating about the project implication if the assumption turns out to be unreliable.

According to Colin Drury, NPV depends upon various variables like initial outlay, investment costs and their components, selling units, selling price, sales volume, discount rates, and interest rates. As NPV requires various assumptions so to determine how sensitive they are and to know about their extent sensitivity analysis is required. He also states that “through sensitivity analysis managers are likely to evaluate how sensitive and responsive NPV is to changes for the variables which are used to calculate it”. (Zhamoida, Matsiuk, 2011).

Scenario Analysis:

Scenario Analysis is systematic method which enables a manager to evaluate that how financial analysis results would change under known circumstances. It is estimating an expected value of a portfolio after a given period of time. Expected value of the portfolio is affected due to various reasons like changes in the interest rate, time value of money. When an investor considers different NPVs of several portfolios, it is called as scenario analysis. This can be very difficult sometimes because of uncertainty that is, may be the future outcome is entirely unexpected. Both scenario and sensitive analysis can be useful when evaluating the best portfolio. Sensitive analysis gives an idea about uncertainty involved in a portfolio. In this the investor came to know that how the outcome is based in certain variable. Whereas in scenario analysis the investor makes a decision that which outcome is most likely to happen? This approach examines a number of scenarios which are alike, and involves confluence of factors. Scenario analysis can play an important role in complex situation. In case of weak scenario that is weak economic condition hence the investor would expect the unit sales would be lower, that would result in low cost. Whereas in case of strong market condition it is expected as sales to rise and cost as inflated. This explains that how the assumptions under NPV can vary under the alternative scenario (Moles, Parrino & Kidwekk, .2011).

Scenario analysis in relation with capital budgeting:

Scenario analysis provides a means to evaluate the variability in the capital budgeting decision like NPV. Under this, analysts’ estimates the expected cash flows that are called as base case scenario. From base case scenario, two condition can be derived that are best market condition and worst market condition, under each market condition NPV is calculated, this would give an idea to investor that in which project’s NPV will lie ( Lee & Lee,2006 ).

Capital asset pricing model (CAPM):

CAPM calculates equity’s expected return related to a particular firm. In finance one of the most important things to be understood is the risk and return analysis. It is said that the more you risk take the more the return would be. Risk and return both goes in a positive direction. But this is only useful for risk takers. Because risk takers dare to take more risk in exchange of getting more returns, whereas risk avoiders are those who usually want regular return with a minimum rate of risk.

Hence CAPM is the model used by finance professionals to calculate the required return with given rate of risk. CAPM model lays some assumptions which are discussed as below:

Investors are wealth maximizes- this means investor will select an investment on the basis of standard deviation and expected return.

Unlimited borrowing limit- means unlimited funds can be borrowed by investor or can be lend at a zero risk rate or risk free rate.

Same expectations- all the investors have same expectations regarding the project.

Fully divisible- all the financial assets are fully divisible.

There is no transaction cost

No taxes are there.

Market prices cannot be influenced by investor.

All the quantities of financial assets are given and certain.

All the information is available to the investors- this is not usually done because some information is intentionally hided by the directors.

The CAPM model consists of two elements: The capital market line (CML) and the security market line (SML).

Capital market line (CML):

In 1950’s Harry Markowitz wrote his doctoral dissertation in which he discussed about CML. He said CML is kind of graph which is originated from the CAPM model. CML is a line drawn as tangent from the risk free asset point to the feasible region of risky assets. In a particular portfolio the CML is used to determine its required rate of return. This analysis depends upon the amount of risk involved and rate of return of a particular portfolio. The CML depicts the return and risk relationship for efficient portfolio and shows the exact risk measurement involved in the portfolio (Vijendra.S, 2016).

When risk free assets are combined with market portfolio, it is more capable of producing a high return. The concept of CML is given by combining the risk free assets and market portfolio.cml is usually preferred by experts because in the portfolio addition of risk free assets is considered. “In 1952’s Harry Markowitz said that the optimal portfolio does not only mean securities with higher returns or lower risk, rather it is the aim of an investor that optimal portfolio should balance securities in such a way that matches the greatest potential returns with an acceptable degree of risk for a given level of return. The point where optimal portfolio lies is known as efficient frontier.”

The CML does not specify individual securities risk return relationship (as that can be calculated by security market line that is SML). Only those portfolios that do not pose any divertible risk can be calculated by CML. However when the risk/reward relationship is to be calculated on individual securities, SML should be used. CML uses no risk investments. Here only efficient portfolios are included. SML consists of two types of risk: unsystematic risk and systematic risk. Unsystematic risk is that risk which can be diversified by diversification in the portfolio, whereas systematic risk is that which cannot be diversified from diversification, for example legal and political factors.

Equation of the CML:

E(Rp) = xE(Ry)+(1-x)Rf

Where: (1-x) = the portfolio percentage which is invested in the risk free asset

x= the portfolio percentage which is invested in risky assets

Rf= the risk free interest rate

E(Ry)= the expected return of the risky asset portfolio

The capital market line and market portfolio

All the investors lie upon the CML as shown in figure. In this risky portfolio are denoted by M, risk free assets are denoted by E (Rp). Risk avoiders lie on the left of M such as C, whereas risk takers lie on the right of point M such as L (Barlow.J.F. 2006).

Similarities between capital asset pricing model and capital market line:

  • The equilibrium relationship between expected return on securities and their co variances with the market portfolio is called as Security market line which can also be referred as CAPM.
  • CML and CAPM both are positively co related by which it can be said that it is the perception of an investor that more the risk would be taken the higher would be the return.
  • CAPM and CML both are used to determine to select portfolio, hence they are a good tool to use for investment analysis and portfolio management (Reilly & Brown, 2011).

Differences between CAPM and CML:

  • CML not only represents the efficient frontier but also tells about the equilibrium relationship between E(r) and ? for all efficient portfolios.
  • CML describes the equilibrium relationship between those who don’t posses any unsystematic risk.
  • CAPM can hold all the securities and portfolio whether efficient or inefficient. Whereas CML can hold only one efficient portfolio.
  • In CML, risk is measured by the portfolio’s standard deviation whereas, in CAPM the risk is measured by a beta coefficient (measurement of systematic risk) (Krichene, 2013).
  • CAPM is not realistic because it assumes that investors will choose the portfolio in the basis of risk and return only, here transaction cost, information cost, brokerage, and taxes are ignored. Whereas in CML model investor chooses the portfolio on the basis of market risky portfolio and riskless securities.
  • CAPM model involves a tradeoff between risk and return which means, the higher the risk, higher would be the returns whereas in CML the investors estimates the return in the exchange of bearing of risk in a portfolio.
  • CAPM is used to determine the firm’s cost of equity, hurdle rates, cost and returns, risk premium. It is a line for any portfolio which include inefficient also, whereas in CML it has only efficient portfolio.

Conclusion:

Corporate decision making is a crucial decision in any organization to be taken by corporate managers. All the decisions to be made by the organization are to be based upon the decision formed in corporate decision making. For effective running of an organization it is very necessary to continuously review the decisions taken and suggestible steps must be taken. For taking accurate corporate decision making it is very necessary to involve other level managers also. Before taking the decision taken by managers the question to be answered is what would be the decision, criteria for the decision, what information would be required and at whom there would be burden of proof, what role is to be played by whom, and what would be the timeline for both the decision and execution.

References:

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