Question

You are considering investing in Varco plc and have decided to calculate the value of the company using some of the techniques you have covered in your University course. After a considerable amount of research you have decided that an appropriate risk free rate of return is 6.5% and the market rate of return is 12%.

You have also found various financial web sites that have given you an average beta of 1.9.

Required:

a. Discuss why knowing a company’s beta is important when making an investment

    decision. (You should relate your answer to Varco plc.)

b. Use the capital asset pricing model (CAPM) to calculate the expected return of

Varco’s equity.

c. Discuss the theoretical and practical difficulties in using the CAPM to calculate the expect return on a particular share.

d. In the context of the CAPM explain what is understood by the Security Market Line (you may find that drawing a diagram helps here) and what would happen if a share was not on the Security Market Line.

Answer 1

Answer-a:

A Beta is a measure of a stock's volatility in relation to the market. By definition, the market has a beta of 1.0, and individual stocks are ranked according to how much they deviate from the market. A stock that swings more than the market over time has a beta above 1.0. If a stock moves less than the market, the stock's beta is less than 1.0. High-beta stocks are supposed to be riskier but provide a potential for higher returns; low-beta stocks pose less risk but also lower returns.

Answer-b:

Expected return of Varco's return under CAPM = Risk Free rate + Beta × (Market Return - Risk free rate)

= 6.5 + 1.9 (12 - 6.5)

= 6.5 + 10.45 = 16.95%

Answer-c:

Capital assets pricing model is the model tested under Capital Market Theory. This model helps the investor build his portfolio of assets through the use of Beta. Although it is theoretical, the practical application of this is the use of market Beta and individual scrip Betas to select the scrips suitable to the preferences of investors, so that the returns are maximised for the given level of risk.

(i) A statistically reliable beta factor might not exist for the shares of many companies. Since beta is at the heart of CAPM, it may not be possible to figure out the cost of equity of all companies using CAPM.

(ii) It is difficult to determine some crucial information such as risk free interest rate and the expected return on market portfolio. For one, there are multiple risk free rate. For other, markets are volatile and it varies over time.

(iii) The model focuses only on return and not how return is earned. It assigns equal prominence to both capital gain and dividend.

(iv) By concentrating only on systematic risk, other aspects of risk are excluded.

(v) The CAPM has serious limitations in real world, as most of the assumptions, are unrealistic.

Answer-d:

Security market line (SML) is the graphical representation of the Capital Asset Pricing Model (CAPM) and gives the expected return of the market at different levels of systematic or market risk. It is also called ‘characteristic line’ where the x-axis represents beta or the risk of the assets and y-axis represents the expected return.

E(R,) Undervalued Stocks Security Market Line E(RM) Overvalued Stocks Rf Systematic risk

• All the shares which are correctly priced are represented on SML
• The shares which are above the SML are undervalued as they give the higher expected return for a given amount of risk.
• The shares which are below the SML are overvalued as they have lower expected returns for the same amount of risk.