Strategic Finance Notes - 2

Q.8. How is CAPM model helpful? Detail out the model and its theory.
Ans Capital Asset Pricing Model (CAPM)

Introduction: The capital Asset Pricing Model (CAPM) is an equilibrium model, which describes the pricing of assets, as well as derivatives. The model concludes that the expected return of an asset(or derivative) equals the riskless return plus a measure of the assets non-diversifiable risk (“beta”) times the market-wide risk premium (excess expected return of the market portfolio over the riskless return). That is:

Expected security return = Riskless return + beta x (expected market risk premium)
It concludes that only the risk, which cannot be diversified away by holding a well-diversified portfolio (e.g. the market portfolio) will affect the market price of the asset. This risk is called systematic risk, while risk that can be diversified away is called diversifiable risk.

The CAPM asks what is the value of an asset (or derivative) relative to the return of the market portfolio. Because of this, the option models are often referred to as “relative” valuation models, while the CAPM is considered an “absolute” valuation model. However the model is only valid within a special set of assumptions.

Assumptions of CAPM
Investors are risk averse individuals who maximize the expected utility of their end of period wealth.

Implication: The model is a one period model.
· Investors have homogenous expectations (belief) about asset returns. Implication : all investors perceive identical opportunity sets. This is, everyone have the same information at the same time.
· Asset returns are distributed by the normal distribution.
· There exists a risk free asset and investors may borrow or lend unlimited amounts of the asset at a constant rate: the risk free rate (k).
· There is a definite number of assets and their quantities are fixed within the one period world.
· All assets are perfectly divisible and priced in a perfectly competitive marked. Implication: e.g. human capital is non-existing.
· Asset markets are frictionless and information is costless and simultaneously available to all investors.
· There are no market imperfections such as taxes, regulations or restrictions on short selling.

Rationale of CAPM:
This method of valuing assets and calculating the cost of capital for an alternative i.e. the capital asset price model (CAPM) has come to dominate modern finance. The rationale of the CAPM can be simplified as follows.

Investors can eliminate some sorts of risk known as Residual risk or alpha, by holding a diversified portfolio of assets. These alpha risks are specific to an individual asset, for example, the risk that a company’s managers will turn out to be no good. Some risks, such as that of a global recession cannot be eliminated through diversification.

So even a basket of all the shares in a stock market will still be risky. People must be rewarded for investing in such a risky basket by earning returns on average above those that they can get on safer assets, such as treasury bills. Assuming investors diversify away alpha risks, how an investor values any particular asset should depend crucially on how much the asset’s price is affected by the risk of the market as a whole.
The market’s risk contribution is captured by a measure of relative volatility. BETA, which indicates how much an asset’s price is expected to change when the overall market changes. Safe investments have a beta close to zero: economists call these assets risk free. Riskier investments, such as a share, should earn a premium over the risk free rate. How much is calculated by the average premium for all assets of that type, multiplied by the particular asset’s beta.

Pronounced as though it were spelled cap-m, this model was originally developed in 1952 by Harry markowitz and fine tuned over a decade later by others, including William Sharpe. CAPM describes the relationship between risk and expected return, and it serves as a model for the pricing of risky securities. CAPM says that the expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium. If this expected return does not meet or beat our required return, the investment should not be undertaken.

The commonly used formula to describe CAPM relationship is as follows:
Required (expected return)= RF rate + (Market return – RF rate)* Beta

Implications of CAPM
· Investors will always combine a risk free asset with a market portfolio of risky assets. They will invest in risky assets in proportion to their market value.
· Investors will be compensated only for that risk which they can’t diversify. This is the market related risk.
· Investor can expect returns from their investment according to the risk.

The concept of risk and return as developed under CAPM have intuitive appeal and they are quite simple to understand. Financial managers use these concepts in a number of financial decision making such as valuation of securities, cost of capital measurement, investment risk analysis etc.

Limitations of CAPM:
· Unrealistic assumptions: CAPM is based on a number of assumptions that are far from the reality. For e.g. its very difficult to find a risk free security.
A short term, highly liquid govt. security is considered as a risk free security. Its unlikely that govt. will default but inflation causes uncertainty about the real rate of return.

The assumption of the equality of the lending and borrowings is also not correct. In practice these rates differ. Further, investors may not hold highly diversified portfolios or the market indices may not be well diversified. Under these circumstances, CAPM may not accurately explain the investment behavior of investors and beta may fail to capture the risk of investment.
· Testing CAPM Most of the assumptions of CAPM may not be very critical for its practical validity. What we need to know therefore, is the empirical validity of CAPM. We need to establish that beta is able to measure the risk of security and that there is a significant correlation between beta and the expected return.
· Stability of BETA : Beta is a measure of a security’s future risk. But investors don’t have the future data to estimate beta. What they have are past data about the share prices and the market portfolio. Thus, they can only estimate beta based on historical data. Investors can use historical beta as the measure of future risk only if its stable over time. This implies that historical betas are poor indicators of the future risk of securities.

CAPM is a useful device for understanding the risk return relationship inspite of its limitations. It provides a logical and quantitative approach for estimating risk. Its better than many alternative subjective methods of determining risk and risk premium. One major problem in the use of CAPM is that many times the risk of an asset is not captured by beta alone.

Q.9 What are the different dividend theories? Explain their application with the Indian context.
Ans Different Dividend theories:

· Bird in Hand Theory:

The conclusions of Miller and Modigliani- that, dividend policy does not matter – presented a strong challenge to the conventional wisdom of that time. Finance theorists and corporate mangers believed that investors preferred dividends to capital gains and that a firm could increase (or at least support) the market value of its shares by choosing a generous dividend policy.

At that time, the most popular argument for dividend was the “Bird in the hand”- Theory. It holds that dividends (a bird in the hand) are preferred to retained earnings (a bird in the bush) because the latter never materialize as future dividends (it can fly away). This is obvious as the risk of having money today is definitely less than risking your money for returns in the future.

At first glance, this theory seems to be reasonable, especially in the light of the fact that a higher dividend stocks tend to be lower on the risk spectrum of common stocks. And other things being equal, less risky stocks are more expensive than higher risk stocks with the same expected future cash flow.
This theory from Myron Gordon is rather an argument about investment policy than about dividends.

· Smoothing Theory

One of the first papers on the subject dividend policy, was published by John Lintner in 1956. He conducted a series of interviews with mangers about their thinking on the determination of dividend policy. His results can be summarized in four stylized facts:

1. Firms have long-run target dividend payout ratios. Mature companies with stable earnings generally pay out a high proportion of earnings; growth companies have low payouts.
2. Managers focus more on dividend changes than on absolute levels. Thus, paying a Rs. 2.0 dividends is an important financial decision if last year’s dividend was Re. 1.00, but no big deal if last year’s dividend was Rs. 2.00.
3. Dividend changes follow shifts in long run, sustainable earnings. Managers “smooth” dividends. Transitory earnings changes are unlikely to affect dividend payouts. This also helps to keep investors happy.
4. Managers are reluctant to make dividend changes that might have to be reversed. They are particularly worried about having to rescind a dividend increase.

· Tax Differential Theory

According to this theory, since dividends are effectively taxed at higher rates than capital gains in most countries, investors require higher rates of return on stocks with high dividend yields.

The theory says, a firm should pay a low (or zero) dividend in order to minimize its cost of capital and maximise its value. The tax system may tend to favour retention of profit and limit dividend. Thus low dividend yield shares have been likely to be in great demand by high rate taxpayers, who prefer a low dividend payout and a high rate of earnings retention in the hope of an appreciation in the capital value of the company.

Small shareholders may prefer relatively high dividend pay out rate. The dividend policy of such a firm may be a compromise between a low and a high payout.

· Residual Theory

According to residual theory of dividends, the firm should follow its investment policy of accepting all positive NPV projects and paying out dividends if and only if funds are available. The focus is on growth. The discounting factor in the calculation of NPV would be equal to greater than the cost of capital K.

If the firm treats dividend as a residual, then the dividend can vary highly from period to period depending upon the opportunities available and the investment plan and operating results of the firm. If a firm attracts investors falling into a particular dividend clientele, it suggests that the firm should maintain fairly stable dividend policy. The residual dividend policy is used by most firms to set a long run target payout.

· Span of Control Theory:

Managers in an organization look at the cash flows generated from the operations as an important and convenient source of new capital. The professional managers prefer to have a large span of control as measured by the number of employees, sales, market value, total assets or total expenditure. In pursuit of managerial objective of increasing the span of control, directors are expected to prefer retention of profits to distributions.

Retention increases status, remuneration and security of mangers. Also increases in the firm’s investment schedule should result in growth in the value of shares to the extent that retained cash flows are reinvested in profitable projects.

· Investor Rationality Theory

Shefrin and Statman (1984) supported their argument based on the psychological preferences of individual investor. Their argument is that an investor who wishes to conserve his/her long run wealth could stipulate that portfolio capital should not be consumed, only dividends.

The investor can select dividend payout ratio that conforms to his/her desired consumption level. Thus even though taxes and transaction costs may favor capital gains, an investor may find cash dividends attractive and hence be willing to pay the appropriate premium. The investor then would invest in a portfolio of shares to meet h\this need. Some of the investments would be in shares with high payout ration for consumption needs and others with low payout ratio for capital appreciation.