4.8. Applying CAPM – a no debt case

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From the course by Moscow Institute of Physics and Technology

Principles of Corporate Finance – A Tale of Value

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Moscow Institute of Physics and Technology

Principles of Corporate Finance – A Tale of Value

ratings

Course 2 of 5 in the Specialization Understanding Modern Finance

The study of Corporate Finance seems to be a very generic part of business education. Still, it either falls in the trap of intimidating formulas or is superficially journalistic. Both extremes preclude the understanding of the core finance ideas, concepts, and models. This Course is an attempt to avoid the above extremes. We discuss the core basis and mechanisms of modern corporate finance in a learner-friendly way. We will analyze the market’s most fundamental problems, realize the intrinsic interests and preferences of investors, reveal the true meaning of specific financial terms, and uncover important issues that are so often ignored in choosing and valuing investment projects. The learners will gain insight into the essence of corporate finance. They will be able to use the obtained knowledge and skills to successfully advance in their career at a financial institution, as well as in the area of financial management at non-financial businesses.

From the lesson

Risk and Return – From Basics to Reality

In Week 4 we study risk and return. We present a stochastic mathematical model of risk and apply it to find the returns and standard deviations of portfolios of assets. We discuss diversification and the role of special portfolios – the riskless portfolio and the market portfolio – in approaching asset risk. We demonstrate how any asset contributes to the market risk and introduce the β coefficient. Then we derive the capital asset pricing model (CAPM) and study how it is used on examples. We discuss the application of the company cost of capital (CCC) rule to choosing investment projects. Then we use CAPM to determine the cost of capital – first, for an equity-financed company and then in the general case with debt and equity. We present the weighted average cost of capital (WACC) formula and discuss it. Finally, on an example we study the steps in applying CAPM.

4.1. Mathematics of risk8:36

4.2. The expected return and the standard deviation for a portfolio of securities. Some empirical evidence9:56

4.3. Diversification. “Special” portfolios6:58

4.4. Contribution to the portfolio risk. β6:22

4.5. Efficient portfolios. The market portfolio’s efficiency7:21

4.6. Capital asset pricing model (CAPM). Examples9:59

4.7. The company cost of capital (CCC) rule10:03

4.8. Applying CAPM – a no debt case4:05

4.9. Applying CAPM – the general case. WACC13:14

4.10. Steps in applying CAPM – an example15:40

4.11. Conclusions. The roadmap to determining WACC. Some objections to using normal distributions7:42

Meet the Instructors

Konstantin Kontor
Director and Professor of Finance and Strategy
American Institute of Business and Economics (AIBEc)

Well, let's now see how we use CAPM to come up with

the right estimate of the expected return for any asset.

Well, we will start, again,

I'll put from CAPM to r's.

And let me start with the most trivial case.

I will put a market balance sheet of a company with no debt.

So here are assets,

and here we know this is V,

value of the company,

and this is liabilities and net worth,

and there is no debt.

This is all equity.

Now, see what happens.

I'm using this trivial example to emphasize one very important thing.

That oftentimes, what we observe on the market is this side,

because for example, if there is a company,

and let's say this company is private,

so there is no stock traded,

and we would like to see what is the good proxy for

seeing what's going on with the assets of this company,

what's the risk of that?

And oftentimes we observe the behavior of the stock of some other companies.

Now, the origin of risk is always on the left side.

This is the asset bar because risk is born here.

Now, the only challenge for us is to

proceed with the path that will borrow some of the data,

some of the information from the market for some other companies,

and then we'll have to compare them and impose them on our project in the correct way.

So the discussion in the next episode will be devoted to that,

and then I will give you detailed example of that.

So the idea is what?

If anything happens to your assets,

then this line fluctuates.

Let's say, you built another plant,

it's here because we added the box here.

Something happened to our plant,

it's got burned down or destroyed, God forbid.

So, we are up here.

But you can see that all changes in this line,

this is the same on the assets side as on the equity side,

and we can say that for this trivial case,

we can say that as long as the values are the same,

so V is always equal to E and therefore,

we can say that clearly,

the beta of this firm is equal to beta of equity.

And also, the return for the whole firm is equal to,

well, in this case, it will be rF plus

beta for the firm, rM minus rF.

This is sort of a general formula,

but in this case,

we can easily say that this is the same as beta equity.

Now, that is the main reason that I produced,

such a trivial example.

So in the next episode,

we will remove this assumption and we will

study more general case with both debt and equity,

and we see that then,

we will have to treat the right side of the market value,

the balance sheet as at equivalent portfolio to the left side.

And then clearly, we would say that to the extent,

the left side behaves exactly as the portfolio of debt and equity.

Therefore, we'll be able to come up with the well-known formulas that take into

account these proportions of debt and equity on the right side of the balance sheet.

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