Capital Asset Pricing Model

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Capital Asset Pricing Model

• Presented by
• Ryan Williams
• Wendy Haryanti
• Daniel Suchomski
• Alex Stewart

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PURPOSE

• To develop a likely range of IBMs Cost of Equity
  using the CAPM Model

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IBM

• Develops, manufactures, and markets advanced
  information processing products.
• Including
• computers
• software
• networking systems
• other information technical related services

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CAPM MODEL

• Ke Krf (Km-Krf)B
• Ke Return on Equity
• Krf Risk Free Rate
• Km Expected Market Return
• B Beta

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Assumptions about Km

• Historically, IBM has used the
• S P 500 as the market portfolio.
• WHY?

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Why S P 500?
1. The SP 500 contains 75 of all the value of
the stock market. 2. It contains the longest
history of Market returns, making it the industry
norm.
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T-Bills or T-Bonds ?

• For long term forecasts of Ke, IBM will be using
  20 yr T-Bonds.
• WHY?

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Why T-Bonds?

• For long term estimates, we want to use a rate
  that has long term inflation built into it.

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Beta A measure of how sensitive an individual
stocks return is relative to changes in Markets
return. Mkt Beta 1.0 Go to Excel

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Time Series of IBM Beta
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Confidence Intervals for IBMs Beta

• Based on Regression, Beta .804
• 95 confidence .003 - 1.6
• 68 confidence .40 - 1.21

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Because Betas tend to Regress towards 1.0, and
the uncertainty that surronds a Beta estimate, we
will use an adjusted beta in our Cost of Equity
Evaluation.
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Adjusted Beta

• Adj Beta 2/3(.804) 1/3(1.0)
• Adj Beta .869

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Market Risk Premium

• The premium that investors require
  for bearing the risk of an Average stock

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Assumptions for RPm

• The SP will be used as the Mkt return.
• The Risk free rate will be represented by yield
  to maturity on
• Long Term bonds.

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Two Approaches to Estimating Market Risk Premium

• 1. Prospective
• 2. Historical

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Prospective

• Estimate the expected return on stock market and
  then subtract the current risk free rate.
• Problem Requires estimates of future dividend
  growth

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Historical

• Calculate the average risk premium which
  investors have actually earned in the past.

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Logic of Historical

• On average, investors will receive what they
  expect. So lets look at what they have received
  to estimate the risk premium they have desired in
  the past.
• Go to Excel

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Geometric Estimate of RPm

• RPm Geometric SP - Geometric LT T-Bond
• 5.61 10.71 - 5.10
• RPm 5.61

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Risk Free Rate Krf

• We will be using todays Yield to Maturity on 20
  year T-Bonds
• Krf 6.5

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Range of CAPM

• Range of Beta (68) .4 -1.21
• 1. Beta .4, krf 6.5, RPm 5.61
• CAPM 6.5 (5.61).4 8.74
• 2. Beta 1.21, Krf 6.5, Rpm 5.61
• CAPM 6.5 (5.61)1.21 13.29
• CAPM Range, (8.74-13.29)

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Final CAPM Calculation

• CAPM Krf (RPm)B
• 6.5 (5.61).869
• CAPM 11.37

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Limitations of CAPM

• Assumptions of CAPM
• Beta Stability
• Fama - French Study
• The CAPM today

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Assumptions of CAPM

• 1. All investors can borrow and lend an
  unlimited amount at a given risk free rate of
  interest.
• 2. No transaction costs
• 3. No Taxes

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Beta Stability

• Past Betas for individual stocks are historically
  unstable.
• Therefore not good proxies for future estimates
  of Beta.

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Is Beta Useful?

• Yes, It is useful when measuring the risk
  associated with a portfolio of stocks.

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Betas in Portfolios

• Number of Stocks
• 1 2 4 7 10 20
  50
• R2 between Beta Estimates
• .36 .53 .71 .77 .86 .95 .96

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Fama -French Study

• Found no relationship between Beta and
  Return
• Concluded that firm size and market book ratios
  give a better much better estimate of return

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Conclusions of CAPM

• Although CAPM has its limitations , it is a
  widely accepted tool in todays business world.

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THANK YOU
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