Question

Describe how, by use of the capital asset pricing model, you might select a suitable
risk discount rate to use in profitability measurement.

(This will be a presentation question, please guide thoroughly. Thank you!)

Answer 1

Capital Asset Pricing Model(CAPM)

What is CAPM?

CAPM is the relationship between systematic risk(i.e.Market risk) and expected return for assets, particularly stocks.

Term 1: Market risk here means risks which are not in control of the organisation. E.g Interest rate risk, equity price risk,Forex risk, etc.

CAPM is used to select a suitable risk discount rate to use in profitability measurement.

Term 2: Risk discount rate aka risk free rate of return(denoted as Rf)is the rate used in the calculation of the present value of a risky investment.

Term 3: Profitability measurement here means that a given level of risk how profitable will your investment be. is the expected gain worth the risk of the investment.

Profitability is the expected return on investment.(Denoted as: ERi)

The profitability of your investment should be more than the Risk-free rate of return ,(ERi>Rf)

This is the main idea behind CAPM, let us now understand the formula and other variables which will help us understand the CAPM model calculations better.

FORMULA:

ERi= Rf =Bi ( ERm - Rf)

Expected return on investment= risk free rate of return = beta of investment ( Expected return of market- Risk free rate of return)

Explanation and example.

ERi( Expected return on investment): Refer term 3.

Rf( risk free rate of return): Refer term 2.

Bi(beta of investment): TERM 4: Beta is measurement of how volatile (risky) is your investment(stock)in relation to the market. It takes into the account both systematic and unsystematic risks.

1) B=1

Exactly as volatile as the market.

Market increased by 5 points your investment increases by 5 point. Vice versa.

2) B>1

More volatile than the market.

Market increases by 5 points, your investment increases by 10 points.

3) B<1

Less volatile than the market.

Market increases by 5 points , your investment increases by 2.5 points

4) B<0

Negatively correlated to the market.

Market increases by 5 points, your investment falls by 5 points.

5) B=0

Uncorrelated to the market.

Market increases by 5 points, your investment has no effects.

ERm(Expected return of the market): Expected return of the market is the rate of return you will get on your investment as per the market.

ERm should always be more than the risk free rate of return.(ERm> Rf)

This is necessary because of the concept of the market premium.

(ERm - Rf)= Market premium

TERM 5: Market premium is the return expected from the market above the risk free rate of return.

EXAMPLE