Question

An analysis of The Walt Disney company required rate of return using the CAPM measurement

Answer 1

Answer :-

Capital asset pricing model (CAPM) describes the linear relationship between risk-return trade-off for the securities / portfolios. CAPM method distinguishes between risk of holding a single asset and holding a portfolio of assets. There is a trade-off between risk and return. A graphical representation of CAPM method is the security market line, (SML), which indicates the rate of return required to compensate at a given level of risk. The risks to which a security / portfolio is exposed are divided into two groups, diversifiable and non-diversifiable.

The diversifiable risk can be eliminated through a portfolio consisting of large number of well diversified securities. Whereas, the non-diversifiable risk is attributable to factors that affect businesses like interest rate changes, inflation, political changes etc. As diversifiable risk can be eliminated by an investor through diversification, the non-diversifiable risk is the only risk a business should be concerned with. The CAPM method is solely concerned with non-diversifiable risk (systematic risk).

In CAPM method, the non-diversifiable risks are assessed in terms of beta coefficient, β, through fitting regression equation between return of a security / portfolio and the return on a market portfolio. CAPM method is developed with the main goal to formulate the return required by investors from a single investment or a portfolio of assets. The required rate of return is defined as the minimum expected return needed so that investors will purchase and hold an asset. Here is the formula for calculating required rate of return using CAPM measurement :-

Required return = Risk free rate of return + Beta * (Market rate of return - Risk free rate of return).

[ In case of Walt Disney Company, risk free rate of return = 2 % (approx), Beta (Systematic risk) = 1.30 and Market rate of return = 12 % (approx). ]

Accordingly, Required rate of return (for Walt Disney company) = 2 % + 1.30 * (12 % - 2 %)

= 2 % + 1.30 * 10 %

= 2 % + 13 %

= 15 %

Conclusion :- Required rate of return (for Walt Disney company) = 15 % (approx).