Question

Question 1 Risk and Return (TOTAL: 25 MARKS)

1.1 Investors often use a method called the capital asset pricing method (CAPM) to measure the required rate of return.

a) Define the capital asset pricing method

b) Explain how CAPM is useful for measuring the required rate of return

1.2 Using an example, discuss how diversification of investments affects the riskiness and expected rate of return of a portfolio.

1.3 Explain how COVID-19 impacts the profitability, liquidity, and cash flow projections of businesses.

Answer 1

Solution

1.1 a) The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free return plus a risk premium, which is based on the beta of that security.

b)The CAPM formula is widely used in the finance industry. It is vital in calculating the weighted average cost of capital (WACC), as CAPM computes the cost of equity.

WACC is used extensively in financial modelling. It can be used to find the net present value (NPV) of the future cash flows of an investment and to further calculate its enterprise value and finally its equity value.

1.2CAPM Example – Calculation of Expected Return

Let’s calculate the expected return on a stock, using the Capital Asset Pricing Model (CAPM) formula. Suppose the following information about a stock is known:

• It trades on the NYSE and its operations are based in the United States
• Current yield on a U.S. 10-year treasury is 2.5%
• The average excess historical annual return for U.S. stocks is 7.5%
• The beta of the stock is 1.25 (meaning its average return is 1.25x as volatile as the S&P500 over the last 2 years)

What is the expected return of the security using the CAPM formula?

• Expected return = Risk Free Rate + [Beta x Market Return Premium]
• Expected return = 2.5% + [1.25 x 7.5%]
• Expected return = 11.9%

1.3. US economic activity is slowing as millions practice social distancing to stem the spread of COVID-19 (coronavirus). As a result, companies are either currently experiencing or anticipating significant constraints on cash and working capital, including potential liquidity challenges.

Cash flow scrutiny will be crucial in the days and months ahead, as will the speed at which the $2 trillion US economic stabilization package that passed on March 27 starts to flow through the economy. Managing cash pressures often falls directly on finance departments during a crisis. Executives will balance these pressures against the prospects for relief, as details continue to unfold about the stabilization package’s significant tax provisions and other measures designed to assist individuals and businesses.

Depending on the industry, many companies will see lower revenue resulting in less cash flow, along with delayed receivables collection, as needs grow to step up payables to important suppliers. Companies should expect to become much more nimble in managing inventory given the uncertainty in the supply chain, which will also place demands on working capital.