Corporate finance Assignment Example | Topics and Well Written Essays - 1500 words

Corporate finance - Assignment Example Blume (1993) had suggested that CAPM provides a model of equilibrium risk/return relationship. The CAPM also denotes that there exists a linear relationship between expected return and non-diversifiable systematic risk which is denoted as beta. This linear relationship is denoted as security market line (SML). In SML, the systematic risk of a share is compared with the risk and return of the market as well as the risk free rate of return for estimating the expected return of a particular share (Arnold, 2008; Pike and Neale, 1999). Figure 1 Source: (Ogilvie, 2008) CAPM defines risk as an extent to which the return of the portfolio of shares or a single share has a covariance with the return in the market. If it is assumed that CAPM correctly defines the capital market, then the risk/return relationship can be established for an efficient market strategy. The CAPM equation represents this relationship and expected return is seen to be a function of the following equation: R = Rf + ? (R m – Rf) Where: R = Expected return on the portfolio or share. Rf = Risk-free rate of return. ? = Beta. It signifies the volatility of the portfolio or the share relative to the market portfolio. Rm = Expected return on the market portfolio. Rm – Rf = Market risk premium (Harrington, 2001; Jones, 1998). Parameters of CAPM The risk-free rate of return: It signifies the return on the asset that has no risk. This indicates that it neither has covariance nor variance with the return on the market. In reality, it is difficult to find an asset of this kind and doubts prevail regarding the actual existence. Various proxies like, treasury bills and government bonds, are used in this stead. However, these proxies are also subjected to inflation and uncertainty and cannot be considered as entirely risk-free (Harrington 2001; Watson and Head, 1998). Return on the market: For CAPM, one of the most important implications is the existence of optimally efficient market portfolio. In t heoretical approach, the market portfolio consists of risky assets that are diversified among the portfolios available. Once this portfolio is held, it is not possible to diversify the risk any further. The market return is the return on the market portfolio, including all the risky assets. Unlike risk-free rate, the market return is difficult to estimate. It is approximated by using the indices of the stock exchange as the proxy for the market. However, issues exist regarding the selection of index to be used as proxy. Beta: It is the measure of non-diversifiable risk and relative measure of risk. It is the risk estimation relative to the market portfolios. In simple words, it measures the price volatility of the share or a portfolio of shares and also, how the expected return of the portfolio or the share will react in consideration to the movement of return in the market portfolio (Moyer, McGuigan and Kretlow 2001; Jones 1998). Hence, beta is the measure for the difference betwee n the return of the various portfolios of share or shares (Ward, 2000; Jones, 1998). Application of Capital Asset Pricing Model in Corporate Decision making CAPM argues that total risk is measured by