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.)

(4 marks)

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

Varco’s equity.

(3 marks)

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

(9 marks)

4. 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.                                                                    

                                                                                                                    (4 marks)

Total 20 marks

Answer 1

a) A beta coefficient is a measure of the volatility or systematic risk of an individual stock in comparison to the unsystematic risk of the entire market. By definition, the market has a beta of 1 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. If a stock moves less than the market, beta is less than 1 of that stock. 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. Thus, in this case, a stock of Varco plc has an average beta of 1.9, which means it is 90% more volatile than the overall market. Its stock price is more sensitive to news and information and will move faster. We can expect high risk, but also there is the possibility of high returns if the stock turns out to be a good investment. This means if we expect overall market to go up by 10%, the stock could rise by 19%. On the other hand, if the market declines by 6%, we can expect a loss of 11.4%.

b) Expected return = Risk free rate of return + Beta * ( Market rate of return - Risk free rate of return ) = 6.5 + 1.9 * ( 12 - 6.5 ) = 16.95%.

c) There are many theoretical and practical difficulties in using the CAPM to calculate the expected return on a particular share. Some of the practical difficulties in using CAPM model are:

i) An assumption used in CAPM is that investors can borrow as well as lend funds at a risk free rate, which is actually not possible. Thus, the minimum required rate of return by an investor might be more than what the model incorporates.

ii) This model focuses on single period time horizon which suggests that investors are only concerned with the wealth produced by their portfolio at the end of the current period. However, this does not hold true in the real world.

iii) CAPM assumes that the rate of return is based only on systematic risk. However, other factors such as relative sensitivity to inflation, dividend payout and others may also impact a security's return.

iv) The Beta values are unstable and vary from time to time. Thus, these are not reflective of the true risk involved.

v) The risk free rate keeps on changing on regular basis with the changing economic circumstances. Thus creating volatility.

CAPM is designed as a theoretical model, this fact is highlighted by the restrictive assumption that the model makes. Some of the theoretical difficulties in using CAPM model are:

i) An assumption of CAPM model is investor rationality. Investors and specifically, retail investors do not tend to act rationally all the time, human beings are emotional and therefore irrational, especially when it comes to money.

ii) Another assumption is that all information is available at the same time to investors. This is not true and even if possible, many investors would not have the know-how to utilize the information.

d) The security market line (SML) is a graphical representation of the CAPM model, where the x axis represents risk in terms of beta and y-axiz of the chart represents expected return. It shows different levels of systematic or market risk of various marketable securities plotted against the expected return of the entire market at a given point in time. SML is commonly used by investors in evaluating a security for inclusion in an investment portfolio. When the security is plotted on the SML chart and it appears above SML, it is considered undervalued because it indicates that the security offers a greater return against its inherent risk. Conversely, if the security plots below the SML, it is considered overvalued in price because the expected return does not overcome the inherent risk.