a) Capital Asset Pricing Model

a) The use of the CAPM simply involves estimating the expected return on the firms common stock through CAPM and using that estimate as the cost of common equity capital. ) !nternally generated funds" !n most #ays$ internally generated funds are the same as equity. %sing internal funds to finance and issuing ne# stock to finance have &almost) the same cost to current shareholders. !nternal funds are simply cashflo#s generated 'y the firms operations that have not 'een paid out as dividends. Management is faced #ith a choice" should they retain these funds and invest them inside the firm$ or pay the funds out to shareholders as dividends and let shareholders invest the funds themselves outside of the firm( !n order for it to 'e optimal to retain the funds$ the firm must expect to earn more than shareholders could earn investing the money on their o#n &given the same level of risk). Thus$ there is a cost to using internally generated funds$ equal to the expected return on the outside investment opportunities not taken 'y shareholders. The cost of internal funds is the same as the cost of ne# equity capital except for flotation costs. There are no flotation costs for the use of retained cashflo#$ #hile there are for ne# issues of stock. Thus$ the cost of using retained cashflo#s is actually slightly lo#er.
3.4.3 The capital asset pricing model

The CAPM is a one-factor model where systematic risk is a function of the correlation between the returns to the firm and the returns to the stock market. The model does not compensate investors for company specific risk, but only for systematic risk. The CAPM is the model most commonly used by regulators to estimate the cost of e uity given that it has a clear theoretical foundation and its implementation is simple. !owever there are different views on the use of this methodology among the finance practitioners mainly because of its simplifying assumptions.

[edit] Capital Asset Pricing Model (CAPM) The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate discount rate in business valuations. The CAPM method originated from the Nobel Prize winning studies of arr! Mar"owitz# $ames Tobin and %illiam &harpe. The CAPM method derives the discount rate b! adding a ris" premium to the ris"'free rate. (n this instance# however# the ris" premium is derived b! multipl!ing the e)uit! ris" premium times *beta#+ which is a measure of stoc" price volatilit!. ,eta is published b! various sources for particular industries and companies. ,eta is associated with the s!stematic ris"s of an investment.

-ne of the criticisms of the CAPM method is that beta is derived from the volatilit! of prices of publicl!'traded companies# which are li"el! to differ from private companies in their capital structures# diversification of products and mar"ets# access to credit mar"ets# size# management depth# and man! other respects. %here private companies can be shown to be sufficientl! similar to public companies# however# the CAPM method ma! be appropriate. The risk free rate(rf) The risk free rate is the e"pected return on an asset, which bears in theory no risk at all #, i.e. whose e"pected returns are certain. $n practice, it is not possible to find an investment that is free of all risks. !owever, freely traded investment-grade government bonds can generally be regarded as having close to %ero default risk and %ero li uidity risk. &hen defining the risk free rate, the relevant market has to be chosen '. The relevant market for the definition of the risk free rate, may be confined to the domestic market, although other country(s government bonds can also be used as a pro"y for the risk free rate. The risk premium The market risk premium represents the additional return over the risk-free rate that investors re uire as compensation for the risk they e"pose themselves to by investing in e uity markets. $t is essentially a measure of investors( appetite for risk and it is a market factor, rather than a company-specific factor. )etermining the risk premium can be a highly contentious issue in regulatory decisionmaking because this forward-looking measure is not directly observable. The tools available may be inade uate since they derive a forecast of what the risk premium is e"pected to be based on actual e uity returns rather than the premium that investors demand as compensation for investing in risky assets, which is the appropriate premium for the purposes of the CAPM. To estimate the risk premium we can use e"-post estimations *based on historical investment returns+ or e"-ante estimations *based only on forward-looking considerations+.
Historical beta

,eta estimates are generally obtained through regression analysis of historical evidence of the relationship between the company returns and the market returns. Thus, for publicly traded firms betas can be estimated by regressing stock(s returns *- j+, including both dividends and price appreciation, against the market returns *- m+. -j / a 0 b -m &here 1a2 is the $ntercept from the regression and b2 is the slope of the regression, which corresponds to the covariance *-j, -m+ 3 45 *-m+ and is the beta of the stock. There are a number of services that provide such estimates including 6ondon ,usiness 7chool, ,loomberg, )ata7tream, 7tandard 8 Poor(s and 9alue 6ine. !owever, using historic returns to estimate future values of beta raises the uestion of what is the correct estimation period and fre uency. $n respect to the estimation period, as we have seen before, the most recent period possible is likely to embody market e"pectations

about future returns. :n the other hand, the values of beta fluctuate over the business cycle. Therefore taking only a recent period risks missing information and biasing the results, suggesting that betas should be calculated over as long a period as possible. There is therefore a trade-off between the relevance of the estimation period and the need for a sufficiently long time period to ensure the regression results are robust. Most estimate services use period ranging from 5 to ; years for the regression. The relevant fre uency should be defined in order to have a data set of a reasonable si%e, which can generate a statistically significant estimate of the value of beta. A beta calculated through regression analysis of historical information provides an appro"imation. !owever, estimation errors are likely because betas may vary significantly over time. Therefore, the estimation of the relevant beta from historical information may need to be complemented with other forward-looking approach.