Question

“It is argued that the capital asset pricing model can be used to calculate a project-specific cost of capital for firms.” Analyse the statement above with reference to the key concepts of systematic risk, business risk and financial risk. Relevant examples or illustrations should be given.

Answer 1

Capital Asset Pricing Model(CAPM)

Formula is Expected Return(Re)=Rf+Beta*(Rm-Rf)

where (Rm-Rf)=Risk Premium

Total risk=Systematic Risk+Unsystematic Risk

Total Risk=?i^2*?m^2+Ei^2

Brief Description

CAPM distinguishes between risk of holding a single asset and holding a portfolio of assets.There is aa trade off between risk and return

Systematic risk consists of Interest risk,Purchasing power risk and Market Risk

Unsystematic Risk consists of Business Risk and Financial Risk

The statement is true,CAPM can be used to calculates a projectspecific cost of capital for firms

Cost of capital is calculated by

Particulars Cost Proportion

Equity Ke

Preference Kp

Debentures Kd

One of the aspects is Ke which is the cost of Equity which can be calculated by using CAPM approach

Unsystematic risk can be averted through diversification and is related to random variables

Syatematic risk is market related component of portfolio risk.It is commonly measured by Beta co-efficient

Business Risk incures due to sales and purchases of securities affected by business cycles,technological changes etc.Flexible income securities are affected than fixed rate securities during deression due to decline in their market prices

Finncial risk arises due to changes in Capital structure of the company.It is also known as leveraged risk and expressed in terms of debt-equity ratio

Interest rate risk arises due to change in interest rates from time to time

Purchasing power risk is known as inflation risk

Market risk is a type of sysytematic risk that affects prices of any particular share move up or down consistently for some time periods in line with other shares in the market