CAPM and Capital Budgeting

By Harish N

CAPM, in essence, predicts the relationship between the risk of an asset and its expected return. This relationship is very useful in two important ways. First, it produces a benchmark for evaluating various investments. Second, it helps us to make an informed guess about the return that can be expected form an asset that has not yet been traded in the market.

Capital market theory tells us how assets should be priced in the capital markets if, indeed, every one behaved in the way portfolio theory suggests. The CAPM is a relationship explaining how assets should be priced in the capital markets.

 Individuals are risk averse. Individuals seek to maximise the expected utility of their

portfolio over single period planning horizon. Individuals have homogenous expectations they have identical subjective estimates of the means, variance, and covariance among returns. Individuals can borrow and lend freely at a riskless rate of interest. The market is perfect: there are no taxes; there are no transactions costs; securities are completely divisible; the market is competitive. The quantity or risky securities in the market is given.

The CAPM is reflected in the following equation that relates the expected rate of return of an investment to its systematic risk.
E(Ri) = Rf + (E(Rm) Rf)Bi Where, E(Ri) = Expected return on security i, Rf = Risk free rate, E(Rm) = Expected return on the market portfolio, Bi = Systematic risk of the security i,

Risk free rate: The risk free rate is the return on a security that is free from default risk and is uncorrelated with returns form any thing else in the economy. Market Risk Premium: The market risk premium is the difference between the expected market return and the risk free rate. Beta: Beta can be calculated with the following equation.

Where Cov(Ri, Rm) = Covariance between the return on security i, and the return on the market portfolio Var(Rm) = Is the variance of the return on market portfolio

A line used in the CAPM to illustrate the rates of return for efficient portfolios depending on the risk free rate of return and the level of risk (Standard deviation) for a particular portfolio.

The CML is derived by drawing a tangent line from the intercept point on the efficient frontier to the point where the expected return equals the risk free rate of return

A line that graphs the systematic or market, risk versus return of the whole market at a certain time and shows all risk marketable securities is called SML.

The SML essentially graphs the results form the CAPM formula. The X axis represents risk (beta) and the Y axis represents the expected return. The market risk premium id determined from the slope of the SML

Capital expenditure budget, investment decisions or capital budgeting is a process of making decision regarding investments in fixed assets . Capital budgeting addresses the issue of strategic longterm investment decisions. Capital budgeting can be defined as the process of analyzing, evaluating, and deciding whether resources should be allocated to a project or not.

Capital expenditure have three distinctive features:

They have long term consequences They involve substantial outlays

They may be difficult or expensive to reverse

 Net present Value Benefit cost ratio Internal rate of return

Payback period
Accounting rate of return

The NPV of a project is the sum of the present values of all the cash flows that are expected to occur over the life of the project.

Where, CFt = is the cash flow at the end of year t T = is the life of project r = the discount rate CFo = initial investment

There are tow ways of defining the relationship between cost and benefits Benefit cost ratio = PVB I Net benefit cost ratio = PVB I = BCR 1 I Where, PVB = Present value of benefits I = Initial investment

The IRR of a project is the discount rate which makes its NPV equal to zero. In other words, it is the discount rate which equates the

present value of future cash flows with the initial

investment

Payback period The payback period is the length of time required to recover the initial cash outlay on the project.

Discounted payback period

In this method, cash flows are first converted into their present valued and then added to ascertain the period of time required to recover the initial outlay on the project.

The accounting rate of return, also called the average rate of return, is defined as Profit after tax Book value of the investment The numerator of this ratio may be measured as the average annual post tax profit over the life of the investment and the denominator is the average book value of fixed assets committed to the project.