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HBS Toolkit License Agreement

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Copyright © 1999 President and Fellows of Harvard College

 Capital Asset Pricing Model INTRODUCTION

Contents
Introduction This sheet
Analysis Capital Asset Pricing Model Calculator
Chart Interactive Security Market Line (SML) Graph
Sample Chart Static graph with labels for each component of the SML Graph

Overview
The Capital Asset Pricing Model (CAPM) uses a set of assumptions and
observed data to estimate the cost of equity capital for a company or class of
assets. Managers can then use this estimate to determine whether a proposed
investment or disposal will generate returns greater or equal to those required by
their shareholders.

Key assumptions in CAPM

Systematic vs. Unsystematic Risk
CAPM breaks down the risk of investing in securities into systematic and
unsystematic risk. Note that risk refers not only to the possibility of losing money.
Rather, it refers to the fact that returns on equity investments cannot be reliably
predicted beforehand, and returns will vary over any given time period.

Unsystematic risk can be thought of in terms of unforeseen events, such as the

death of a CEO, a product being more or less successful than anticipated, a
lawsuit, etc. Because the events that cause unsystematic risk are, by nature,
unforeseen, CAPM assumes that they are not correlated with each other.
Variance that is not correlated with other stocks can be reduced (effectively to zero)
by holding a portfolio of securities (this is similar to an insurance company
holding a large number of policies, resulting in a much lower variance than if they
held a single policy). Therefore, unsystematic risk is not ‘real’ risk to the portfolio
investor, and cannot serve as a justification for requiring a higher return. CAPM
therefore effectively ignores unsystematic risk.

Systematic risk reflects the fact that returns on equity investments are
affected by numerous factors that tend to affect the market as a whole.
Economic growth, inflation, changes in interest rates and
investor sentiment all tend to affect the overall market, causing some of
the variance in individual stock returns to be correlated with returns of
the market. Because systematic risk cannot be diversified away, it
justifies requiring a higher return. Indeed, systematic risk is the only
factor that justifies requiring a higher rate of return than the risk-free rate.

Systematic risk is denoted by the symbol B, called Beta. A Beta of 1 indicates

systematic risk equal to the overall market; if the market rose 15% we would
expect an asset with a Beta of 1 to increase in value by 15% as well. A stock with
a Beta of 1.5 would be expected to increase by 22.5%. We would not expect any
change in the price of a stock with a Beta of zero.
 Capital Asset Pricing Model INTRODUCTION

Not all stocks have the same level of systematic risk. A stock’s systematic risk is
determined by the nature of the company’s assets and by the amount of leverage
employed. A highly cyclical business might be more affected by the economy and
interest rates and therefore have a high level of systematic risk. A collection
agency, by contrast, might have a very low level of systematic risk, since it thrives
in difficult times.

Leverage (debt) enhances the systematic risk of an asset by magnifying its

effects. Suppose an asset worth $100 has a systematic risk identical to that of the
stock market. If the market suffered a 10% correction (decline), we would expect
the value of that asset to decline by 10% as well, to $90. However, suppose that
the asset, instead of being financed entirely by equity, had been financed in part by
debt of $50. The asset itself still declined in value from $100 to $90, but the value
of the equity declined from $50 to $40, a drop of 20%. Because of the effect of
leverage, Beta is divided into Asset Beta and Equity Beta.

Predictive Value of the Past

CAPM makes two key assumptions that rely on historic returns to predict both
future returns and investors’ requirements. The first relates to systematic risk. It
would be highly difficult, even in theory, to estimate a company’s systematic risk.
CAPM therefore requires the calculation of Beta using a regression of
historic returns of a security (or of comparable securities if the asset is not publicly
traded) against returns for the overall market. If a company has changed the
nature of its asset base, such as by selling off a division, the historic correlation of
its returns against the market may not be a good predictor of future correlation.

The second assumption typically made in CAPM is that the historic difference
between returns on the equity market (usually going back several decades) and
on risk-free securities represents the risk premium demanded by investors, and
is therefore indicative of the risk premium required by investors going forward.
Note, however, that this assumption is not necessary for CAPM to work, and CAPM
cost of equity valuations can be run based on any assumption for the equity market
risk premium.

Required rate of returns based on assets/cash flows, not companies

Because it is the cash flows of a business that ultimately generate returns, it is
that business or asset class which has a particular beta. Therefore, when using
CAPM to estimate required returns, only the business being invested in or
acquired is looked at,not the other businesses of the investing company. If a
hotel company with a beta of 1.2 decides to diversify into the supermarket
business by buying a supermarket chain with a beta of 0.8, only the supermarket’s
beta of 0.8 is relevant.

This also enables the analyst to use quoted companies to estimate the beta of
privately held companies. Suppose the founding family owns the supermarket
business in question. We cannot measure its beta directly, as there is no daily
stock price to correlate with the market. However, by looking at the betas of a
number of quoted supermarket chains, we can hopefully come up with a
reasonable estimate.
 Capital Asset Pricing Model INTRODUCTION

Directions
These directions provide a general introduction to the contents of each worksheet
in the tool.For more detailed directions place your mouse above the red celltips
located throughout thetool. See this example -->

Analysis Enter your CAPM variables here to calculate the cost of

capital
Chart Adjust the data you input in the Analysis worksheet to
visualize how changes in Rm, Rf, and Beta impact the
cost of capital

Sample Chart Refer to this chart for a description about the SML Graph

You may want to print these directions as a reference guide for this tool.

To start using the tool, remove the sample data from the tool using the Show/Hide
Sample Dataoption under the HBS Menu

Note About Using Internet Explorer

The default setting in Internet Explorer is to open these tools in the Explorer
application insteadof Excel. We recommend against this and provide directions in
the Help section of the HBSToolkit web site to change this default behavior.

HBS Menu
Show/Hide Sample Data:
Show Calculator:
Show/Hide Celltips:
Print Sheet with Celltips:
Set Zoom:
Visit Web Links:
About HBS Toolkit:
Displays or removes sample entries
Launches Windows calculator
Toggles in/out red Celltips in documented cells
Prints Celltip documentation on current sheet
Provides quick access to 80%, 100%, and 125% zoom levels
Links to HBS Toolkit website, Toolkit Glossary, and Toolkit
Feedback, as well as HBS and HBS Publishing web sites
Launches the about box for the HBS Toolkit

Jon B. DeFriese MBA `00 and Chad Ellis, MBA `98 developed this software under
the supervision of Professor Steven Wheelwright as the basis for class
discussion rather than to illustrate either the effective or ineffective handling of an
administrative situation.

Copyright © 1999 President and Fellows of Harvard College

 Capital Asset Pricing Model ANALYSIS

Beta equity (BE) 0.89

Total Debt (Assumes MV = BV Debt) $10,600,000.00
Risk free rate (Rf) 4.50%
Market risk premium (Rm-Rf) 7.00%

Market value of equity (capitalization) $70,200,000.00

Beta asset (BA) 0.77

Cost of asset capital (KA) 9.91%

Cost of equity capital (KE) 10.73%

Formulas:
Earnings per share (EPS) = Earnings / Number shares outstanding
Cost of capital (Asset) KA = Rf + BA (Rm+Rf)
Cost of capital (Equity) KE = Rf + BE (Rm+Rf)
Unlevering the equity beta (BBE)A = [E/(D+E)]*BE
Where:
E = Market value of equity
D = Market value of debt (in first year finance assume that MV=BV)
(D+E) = Market value of the firm

Copyright © 1999 President and Fellows of Harvard College

 Capital Asset Pricing Model INTERACTIVE
CHART

Security Market Line:

Risk/Expected Return Trade-Off with CAPM
25.0% 11.46% Column F Linear Regression for Column I
Column F
Column I Column I Column I Column I

20.0%
Rs (Expected Return)

15.0%

10.0%

5.0%

0.0%
- 0.5 1.0 1.5 2.0
Beta (Systematic Risk)

Rf Rm
Be

Rm - Market Return 12.3%

Be - Equity Beta 0.89

Rs - Expected Return 11.5%

[Be(Rm -Rf)] - Risk Premium 6.96%

Rf - Risk Free Rate 4.5%

Copyright © 1999 President and Fellows of Harvard College

 Capital Asset Pricing Model SAMPLE
CHART

Security Market Line:

Risk/Expected Return Trade-Off with CAPM
9.11% Column F Linear Regression for Column I
25.0% Column F
Column I Column I Column I Column I

This is the
20.0% This line shows Securiy Market
market average Line.
This line shows return (where Beta
where the stock in
Rs (Expected Return)

= 1.0).
question performs.
15.0%

This line is the

risk-free rate
10.0% (usually U.S.
Govt Bond rate).

5.0%

0.0%
- 0.5 1.0 1.5 2.0
Beta (Systematic Risk)

Copyright © 1999 President and Fellows of Harvard College