Finance - Session 13 - WACC/Portfolio Theory/CAPM

What risk is considered and why?

As unsystematic risk can be diversified away, it is not taken into account when determining the required return on a share (i.e. the cost of equity capital). Therefore the only risk to impact on the expected return from a portfolio of well chosen shares is systemic risk. When calculating the expected equity return using the CAPM, it is assumed that the equity share is part of a portfolio and therefore only systemic risk is relevant.

What is beta and how is it obtained?

Beta (B) is a measure of the systemic risk of an individual equity share relative to the systemic risk experienced by the market. For example, a company with a beta of 2, is twice as risky as the market - when market returns rise, this company's returns should rise by twice as much; however, when they fall, this company's earnings will fall by twice as much also. A company's beta is obtained by plotting the returns of the company against the returns of the market over time, and estimating a line of best fit from the pattern that emerges (securities market line).

Wwhat is beta?

Each individual company has a different sensitivity to systemic risk. Some are more sensitive than others. Systemic risk is a key influence on the expected return from an equity share. Systemic risk is commonly measured by the beta coefficient. Beta measures how a company's returns react compared with the market's reaction. Regardless of the movement in equity returns in relation to market influences, the overall market beta is always pegged at 1.

What is the relationship between WACC, earnings and market value of a company?

From examination of the WACC formula, it is evident that there is a direct link between the market value of a company, its earnings and the WACC. For a company to remain attractive to investors it will have to generate returns in excess of its current market value. These are the level of returns required to keep its current investors happy in the two identified companies above.

What are the limitations of WACC?

Other limitations include the fact that some companies will raise funds by issuing floating-rate debt capital. In addition, some debt instruments are highly complicated and do not fall under the theoretical approach adopted in calculating the WACC. However, the WACC still remains a good approximation for calculating a discount rate for use in the evaluation of investment projects. By understanding and appreciating its limitations business managers can adjust the WACC rate in light of the knowledge about capital structures and the riskiness of a project being evaluated. Riskier projects should require a larger return to compensate for the risk and should be discounted using WACC plus a premium for additional risk. The premium to be added is a matter of judgement.

What does portfolio theory say?

Portfolio theory suggests that an investor can diversify away unsystemic risk by holding a well diversified portfolio of shares. The larger the number of differing types of shares held, the more likely that unsystemic risk will be reduced. It is thought that holding eight to ten carefully chosen shares is sufficient to diversify away unsystemic (business/unique) risk.

What is the CAPM's link with risk?

The risk associated with investing in a particular share is that the return received will be different to the return expected. And there are two types of risk that lead to variations from expected return. These risks are categorised as being either specific to a company/industry (un-systemic/business risk) or affecting the whole market (systemic/market risk).

When is WACC appropriate/what assumptions are there?

The weighted average cost of capital (WACC) is an appropriate when: The rate reflects the marginal cost of new capital; The company's capital structure is at its optimal level; The project being evaluated is of the same business risk as the company, and The finance raised is in similar proportions to the existing capital structure.

What is WACC?

The weighted average cost of capital (WACC) is the overall cost of long-term funds invested in a company. The required return on investment should reflect the current risk and returns available in the investment market The WACC is expressed as the cost that would be incurred in raising new capital (i.e. debt & equity) assuming it is raised in the same proportion as the existing structure of a company.

How can risk be classified?

Unsystemic risk (unique/business risk) might include strike action by employees, or a merger with another company. These events will impact on a particular company's expected return, but will not affect the whole market. Systemic risk (market risk) captures events that impact on a large number of companies, for example inflation, interest rate or GDP movements.