Capital asset pricing model (CAPM) explains the relationship between the risk and expected return in a rational equilibrium market. CAPM method is based on several assumptions related to risk, return and equilibrium market. The main assumption is that market returns are properly modeled by a normal distribution and beta (systematic risk) is the sole sources of risk for an asset. Another assumption is that all investors are traded in the market and available to everyone. But generally, the assets are infinitely divisible and can be bought or sold at higher than observed market prices. Another assumption is that there are no expenses associated with trading. It assumes that transaction cost and taxes could not impact on the return on investment, but in the case of huge investment, this assumption becomes unreasonable and impact on the return on investment (Pratt & Grabowski, 2010). Management fees, transaction costs, profit fees, exit penalties, liquidity restriction, etc. are frictional costs of high-volume trading that can make a difference between profit and cost.
CAPM method is useful for financial managers and economics as a method of valuation of securities, stocks and assets through identifying the market risk and expected return on investment. Finance manager uses this technique to evaluate the price of risky security and for defining opportunity costs of investment according to level of risks. Through CAPM, corporations analyze the changes in return, according to time or market, so this method is used for business decisions (Bailey, 2005). On the other hand, weakness of the model comes from assumptions, such as it does not consider taxes and transaction costs that impact on the actual return on investment. CAPM method is based on unrealistic assumption, for example, it is difficult to find a risk free security. Government security is considered as risk free security, but the government default and inflation causes, impact about the real rate of return (Schneider, DiMeo & Benoit, 2005). Betas do not remain stable over time because it is based on historical data that is effective to measure a security future risk. This paper explains the different types of methods used to evaluate risk management techniques in investment appraisal
Accounting Rate of Return
Basically, the Accounting rate of return method is also well-known as the name Average rate of return, or ARR is a financial ratio used in capital budgeting. In addition to this, this ratio does not focus on using the concept of time value of money. Moreover, ARR calculates the return of a company that is generated from net income of the proposed capital investment. Apart from this, it is also analyzed that, the ARR is a percentage return. Say, if ARR = 7%, then it means that the plan is predictable to make seven percents out of each dollar invested (yearly). For case, if the ARR would be equal to or greater than the required rate of return, the project is acceptable. If it is less than the desired rate, it should be rejected. In the same way, In comparing of investments, the higher the ARR, the more attractive the investment. Over one-half of large firms calculate ARR when appraising projects.
In the same way, it can be said that, ARR is known as a straight-line method of colleting quantitative data and information in an effective and proper manner. The accounting rate of return (ARR) method may have some merits:
The method of (ARR) method is considered one of the effective and simple to understand and use. In the same way provides simplicity to the users.
In the current time, the accounting rate of return (ARR) can be used to calculate the information to gain the accounting data. For case unlike in the net present value (NPV) and internal rate of return (IRR) methods, no adjustments are required to arrive at cash flows of the project.
In addition to this, the rules of ARR methods integrate the entire stream of income in calculating the project’s profitability.
The accounting rate of return (ARR) can be defined as most significant and commonly used methods of accounting used by the accounting personnel in order to measure the performance in an effective and more significant manner. As a decision criterion, however, it has serious shortcomings.
Cash flows ignored:
Generally, this method of accounting (ARR) focus on using accounting profits, not cash flows, in appraising the projects. This is one of the most significant limitations of using this method because the profits are based on arbitrary assumptions and choices and also include non-cash items.
Time value ignored:
This value do not focus on the concept of time value of money. For example, the averaging of income ignores the time value of money. In fact, this procedure gives more weight age to the distant receipts.
Alternative Methods of Investment Appraisal
The effectiveness of asset for the business was measured by using the NPV method. In this method, the returns from the investment are compared to the cost of investment. NPV is the most popular and widely accepted method of evaluating investment proposals. NPV considers the time value of money that enhances the accuracy in the project evaluation. NPV evaluates differences between the present value of cash inflows and present values of cash outflows of a project. If the present value of future cash flow is greater than the initial cost of the project then the project will be acceptable. NPV should accept when it is zero or positive (Moyer, McGuigan & Kretlow, 2008). If it is negative, it represents the investor would lose money, so it should not accept. The NPV of a project can be calculated as follows:
NPV= Present values of cash inflows- Present value of cash outflows/Investment
NPV is important for financial appraisal of long term projects. It measures the shortage or surplus of cash flows in future time period. If the organization has other choice of project for the same purpose then the project with highest positive NPV is selected.
Advantages of Net Present Value Methods:
It considers all the cash flows and determines the value of future money in today term that indicates true profit potential from any investment. It also measures the risk of future cash flows. It is also effective to evaluate the project in terms of shareholders’ interest by considering their wealth maximization (Lee, Lee & Lee, 2009).
Disadvantages of Net Present Value Methods:
Disadvantage of this method is that the size of the project is not measured. It is expressed in terms of dollar or currency not for the percentage that reduces effectiveness of the project evaluation. It requires forecasting of future cash flow of the investment proposal that is complex job. It is calculated on the basis of estimated cost of capital which could be affected by future environment changes. The critical point of this method is deciding the discount rate to use in the calculation. Longer life of a project is generally related with higher risk, so it should be discounted at higher rate as discount rate is related to project life and risk associated (Groppelli & Nikbakht, 2006).
Internal Rate of Return Method (IRR):
Organizations used internal rate of return (IRR) method to measure its significance for the business. IRR is the rate of return that an investor will expect to earn on the new investment. IRR is compared with the company’s discounted rate of return. If IRR is higher in comparison to discounted rate of return then the investment is useful for the company and vice versa. Discounted rate of return is determined by considering several factors. The most common factor is risk; if the investor evaluates the high risky investment then they want to higher rate of return (Mowen, Hansen & Heitger, 2011). This method measures how quickly the investors earn their returns. The project should be acceptable, when IRR is greater than the required rate of return. If IRR is less than the required rate of return then the project should be rejected. It is the rate at which the net present value of investment is zero. It is the most popular methods of capital budgeting to evaluate investments.
IRR of a project can be calculated as follows:
IRR= LDR+ (P1-Q)/(P1-P2) ? (HDR-LDR) (Davis & Davis, 2011)
Where: LDR= Lower Discount Rate
HDR= Higher Discount Rate
P1= Present value at lower rate of interest
P2= Present value at higher rate of interest
Q= Net cash outlay
Advantages of IRR Method:
IRR considers all the cash flows during life of the project or machine.
The IRR method considers time value of money, so it determines the value of future money.
IRR method easily compares risk and uncertainty by recognizing the time value of money.
IRR method does not require cost of capital before evaluating the project.
It is a profit oriented concept, so it helps in achieving the objective of maximization of investor’s welfare (Ryan, 2007).
Disadvantages of Internal Rate of Return Method:
IRR is complicated in calculation, so it is difficult to understand and use.
It requires forecasting of future cash inflow of the investment proposal that is difficult to determine.
It gives confusing results in uneven cash inflows.
IRR is not good for comparing two investments or projects.
The estimates of cash inflows generated by project are based on sales and costs that are uncertain for project and not evaluate actual result or return of investment (Shim & Siegel, 2006).
On the basis of the above discussion, it can be concluded that the ARR, NPV and IRR all three methods used to evaluate the risk and return of an investment and each have some advantages and disadvantages.
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