THE COST OF EQUITY, THE C.A.P.M.

AND MANAGEMENT
OBJECTIVES UNDER UNCERTAINTY
JOHN R. GRINYER"

INTRODUCTION

This paper considers the choice of a cost of equity capital rate, for use in capital
budgeting, under the uncertainty typically prevailing in the stock market. It
suggests that the maximisation of shareholders' wealth is likely to be achieved
more by luck than judgement, given that the shareholders' opportunity cost
probably differs from the market's required rate of return and is unknown. The
author therefore contends that the shareholders' wealth maximisation objective
is not operationally sensible as a proxy for shareholder satisficing in the multiple-
objective environment of modern business. He suggests that a shareholder
satisficing objective be explicitly specified for capital budgeting decisions, and he
considers how the Capital Asset Pricing Model (C.A.P.M.) could then be used
to estimate the rate of return required from the investment of equity funds,
using a multi-period analysis recognising the term structure of interest rates.

Appraisal of capital projects presupposes the recognition of an objective function.

Many people now accept that the management of private industry has responsi-
bilities to a variety of interest groups, e.g. employees, creditors, customers,
shareholders and the local and national cummunities. The Trueblood Report (
and the Corporate Report (2) provide evidence of such thinking in the U.S.A.
and in the U.K., respectively, for in specifying the need for the corporation to
report to a number of groups, they implicitly recognise that management has
responsibilities to those groups. As these seem likely to have different, and
frequently conflicting, interests, it initially seems reasonable to suggest that a
singie financial objective based on the requirements of only one subset of the
people to whom management is accountable will be inadequate for decision
purposes. In contrast to such thinking, the literature of financial management
usually assumes the single objective of the maximisation of current share
price.' Such an approach may, however, be sensible because perceived success
or failure in meeting the requirements of shareholders could, via the capital
markets, affect the future availability of funds and the continued control of
the business by its existing management. Failure to satisfy shareholders can
therefore reduce the likelihood of achievement of other management objectives,

*The author wishes to acknowledge the helpful comments received from prof:
R.A, Brealey, h o t M. Bromwich and Mr. F. Fishwick, on early drafts of this
paper. Errors of omission andcommission are, however, his. The author is
Professor of Accountancy at Dundee L'niversity. (Paper received July 1975,
revised August 19 76)

Journal o f Business Finance & Accounting, 3,4(1976) 101

so that such satisfaction may be considered to be a dominant constraint and
an appropriate choice of objective function. Clearly other aims feature in the
analysis of capital projects, but can be considered as constraints and excluded
from the definition of that function. H.A.Simon (4) discussed this type of
approach.

We therefore assume, initially, that the sole aim of management is to maximise

the welfare of the f m ’ s shareholders, as a means of satisfying them, but we
modify this objective at an appropriate point in the analysis. Further assumptions,
adopted throughout the paper to limit the analysis to a comprehensible volume,
are as follows:

1. Firms are considered to be financed entirely by the funds of existing equity

holders, and are not sufficiently large to be able to affect the market price for
money.

2. Taxation does not affect the analyses.

3. If the f m does not invest shareholders’ funds, their alternative investment

is in the national equity markets.

4. On the introduction of uncertainty, the expectations of management and

investors are nonhomogeneous.
We commence our analysis, however, by assuming markets whjch ‘correctly’price
shares, in the Sense that securities sell for sums which adequately reflect the cash
to be derived from holding them and the rate of return expected by the market.
SHAREHOLDER WEALTH MAXIMISATION WITH ’CORRECTLY’
PRICED SHARES

Consider a world in which there were no transaction costs and there was certainty
concerning the cash flows associated with all investment opportunities. Given the
relevant assumptions outlined earlier, the utility of shareholders’ consumption
would be maximised if management accepted all capital projects yielding returns
greater than or equal to the single riskless rate of interest which would prevail.
Such a policy would also maximise current share price, which would be the
present value of the cash flows to be derived from owning the share, when
discounted at the riskless rate. When transactions costs are included in the
analysis, the criterion rate is found to vary depending on whether the ahareholder
is a lender (investor) or borrower (seller of shares).? It is ansumed, throughout
this paper, that he is a lender for the entire period of the project’, lifetime: m
the appropriate rate is found by reference to his alternative invmtment
opportunity, and we maximise the utility of the shareholder’s consumption by
102 John R . Grinyer
maximising his terminal wealth. Figure 1 illustrates the position assuming a two
period world and initial funds of (1-0). Curve 111 shows the cash available to the
shareholder, in periods 0 and 1, with different amounts of investment in the
physical assets available to the fm.Theslope of the curve at any point reflects
the rate of return on the marginal project at that point. Instead of investing in
physical assets the shareholder could invest in monetary claims, e.g. shares, and
the lines LLl and IL, show possible combinations of consumption available by
investing (L-0) and (1-0) respectively in this way. The slope of these lines
refleets the market’s risk free rate of return after adjusting for transaction costs.
Adoption of the maximisation of terminal wealth objective implies that the fm
should enable the shareholder to reach the highest position possible on the y axis,
and that can be done by investing (I-F) in physical assets and the balance (F-0)
in monetary assets - enabling the owner to reach point L1 in period 1. Thus, in
these circumstances, the cut off rate for physical investment should be the
market’s required risk-free rate of return, for the shareholder has always the
opportunity to invest to earn that rate elsewhere.

FIGURE 1
Y

Amount available
in Period 1.

Ll

in
Period 0
We now introduce uncertainty, but retain the assumption that the market
‘correctly’ prices shares. The opportunity cost of investment in the fm’s projects
must now be represented by the rate of return expected by the market on
alternative equities of equivalent risk to the projects, since, by assumption, such
returns equal the actual returns to be earned on those equities? so that that rate
must be the required project cut-off rate. A model which enables the calculation
of the rate of return expected by the market therefore becomes necessary as soon
as we introduce uncertainty into the analysis. Such a model is to be found in the

The cost of equity, the W M and management objectives 103

Sharpe, Lhtner et a1 Capital Asset Pricing Model (CAPM): the simplest form
of which can be defined as fallows:

Rjt it + Bjt (Rmt - it) (1)

where

a weighting relating the premium for systematic risk on share j during period t
to the systematic risk premium for the market as a whole.

R, is the expected return from investing in the market as a whole for period 1
Rjt is the expected return on share j during period t.

it is the “risk free” rate for period t, i.e. the rate available on single-period
risk-free lending.

(R, - it) is the market premium for systematic risk, which is the risk which
cannot be diversified away.

Empirical work6 has suggested that the simple CAPM outlined above is not a
complete description of the way in which the market values capital assets. It is
also recognised that the model is based on somewhat unrealistic assumptions.’
Despite these shortcomings, the CAPM is probably the most developed
empirically-tested theory of security valuation which we currently have, and it
has gained wide academic acceptance and offers a practical approach to the
estimation of required discount rates. On these grounds it seems acceptable, as a
model of market behaviour, for use in estimating rates of return required by
investors. Clearly, ‘correctly’ priced shares are unlikely generally to exist, so we
now remove that assumption.

SHAREHOLDER WEALTH MAXIMISATION WITH ‘INCORRECTLY

PRICED SHARES

Analysis usually considers an ex ante position when, as risk premiums are

expectgd compensation for additional uncertainty perceived at the time of taking
a decision, it is reasonable to expect that equivalent return be required for
equivalent risk, i.e. that the required return should be selected by reference to
the investment’s risk class. We are looking at the stock market aa an alternative
investment to the capital projects under consideration. When a fm invedr
shareholders’ funds, within the fm, the latter are asmuned to lose I -am of

104 John R. Grinyer

cash which would otherwise be generated externally, and to forego the actual and
not an estimated flow - although it is obviously impossible to know the actual
flow at the time of the decision. It is the actual flow which is the opportunity
cost and, if shares are not ‘correctly’ priced, the CAPM derived rate may be an
inadequate surrogate for that cost. This concept is central to be subsequent
analysis, so it seems worthwhile to consider it in greater detail. The following
example illustrates the thinking involved.

EXAMPLE

At a point in time, the equity market operates with a required (expected) rate of
return (R,) of lo%, and the risk free rate of interest (i) is 6%. The risk premium
for investing in the varket iis therefore 4%, and it is that rate which is required by
investors as a whole to compensate them for the disutility of risk-taking. For
ease of understanding, we will assume that cash flows derived from shareholdings
are in the form of perpetuities, so, for every €100 invested in the market,
investors expect to receive a perpetuity of €10 (including €4 compensation for
risk-taking). Their expectations are wrong, and they will actualb receive a
perpetuity of €15, providing a return of 15% instead of the 10%they anticipate.
In this case, we can reason that the opportunity cost of market investment is
either -

(a) a risk-adjusted rate equal to the required risk-free rate 6%, plus the
returns in excess of requirements (15% - lo%), i.e. 11% or

(b) a rate including compensation for risk-taking of the required return 10%
plus the excess return (1 5% - 10%) equals 15%. Note that the difference
between these rates is the risk premium of 4%. The opportunity cost is, in
both approaches, based on actual returns - which are, of course, unknown
at the time of taking the decision to invest. We proceed by using the rate
including compensation for risk-taking (i.e. ‘b’ above).

Of course the impossibility of knowing the opportunity cost ex ante makes it of

little practical value, but use of the concept with ex post information enables us
to consider the likelihood of conventional approaches achieving their stated
objectives. Further understanding of the concept may be obtained by considering
Figure 2, which is Figure 1 altered by the addition of a further line CCl ,which
shows the actual amount which will be obtained in period 1 by investment in the
stock market of (C-0) in period 0. The slope of LLl still reflects the return
expected by the market, but now differs from the actual return. Assuming that
the disutility of perceived risk is fully compensated for by the risk premium
included in the expected return, management could, by increasing the cut-off
rate to the actual opportunity cost (reflected by CCI) and allowing the
shareholders personally to invest more on the share market, have obtained for

The cost of equity, the CAPM and management objectives 105

shareholders a larger amount in period 1 without altering the disutility of
risk-taking. Ideally, it would invest (I-Fl) in physical assets and leave (F, -0)
for shareholders to invest, which is a different solution to one wing the market's
expected rate of return as criterion rate.

FIGURE 2
Y

Amount available
in Period 1

X
0 F Fl I C L Amount availablein
period 0

Even casual observation implies .that, during some periods, investors' expectations
change so dramatically that the general levels of market prices often cannot even
be approxiinations of the actual cash flows discounted at the market's required
rates of return. Consider the behaviour of prices on the New York and London
stock exchanges during the period January 1973 to June 1975. During the years
1973 and 1974 prices fell by almost 50% in New York and by about 70% in
London, then in November 1974 and the first four months of 1975 they rose by
50% in New York and 130% in London. Such major changes in a short period
could only derive from very significant revisions of formerly-held expectations.
The percentages are calculated in money terms but the changes are so marked
that inferences drawn from them would also seem valid in real terms.

The practical implications of the concept of the investors' opportunity cost,

advanced above, can be illustrated using a hypothetical stock and the changes
observed on the London market in 1975. Assume that ownership of a share of X
Limited will actually provide a perpertuity of €0.6,and, at January 1st 1975, the
share price stood at €1 .SO (presumably because investors then expected a much
lower figure of income than will actually be derived from owning the share). By

106 John R. Grinyer

early June 1975,the share price had risen to €3.50 in line with the F.T.
Industrial Ordinary Index. At €3.50,an investor would buy virtually the same
actual stream of income as he could have purchased for €1.50six months earlier.
The long-term return available from investment in X Ltd. was 40% in January
1975,and 17% in June 1975.If X Ltd. represented the shareholders’ alternative
investment, it is this variation which has occurred in the opportunity “cost of
equity capital” during the six-month period, for the rates 40% and 17% represent
apportunities alternative to the firm’s investments. Depending on one’s
assumptions concerning investors’ holding periods, and the pattern of cash flows
to be derived from investing, widely different figures of alternative cost could be
calculated - e.g. at one extreme the investment yields 130% return for a holding
period of six months. These available returns seem likely to be dissimilar to the
rate expected by the market at any time during the period.

Adoption of the objective of maximisation of future share price would, under an

assumption that fuhtre share prices will adequately reflect the underlying cash
flow from the firm, yield a similar analysis. This can be illustrated by elaborating
on the example of X Ltd. as follows.

Assume that

(1) throughout the period January to June 1975 the market expected a
return of 17% from investing in X Ltd.

(2) the company had l,OOO,OOO issued shares at 1st January 1975.

(3) on 2nd January it issued a further 500,000shares for net proceeds of

€750,000.

(4) the €750,000 raised under (3) was invested to yield 20% in perpetuity,
this being greater than the expected rate of 17%.

The stock market price per share in June could then be calculated as follows:
(a) (b)
Without transactions With transactions
3&4 3&4
Total Value EOOOs
Business existing 1st Jan
.6
(- x 1,000,000) 3,530(approx) 3,530(approx)
.17
New business

(”or) --

3,530
880
4,410
”

The cost of equity, the CAPM and management objectives 107

 (a) (b)
Number of issued shares
in June 1,000,000 1,500,000
Average price per share €3.5 €2.9

So the adoption of the expected rate of return as a criterion rate, reduced

future share price below the level which would otherwise have applied, even
when the investments yielded returns in excess of that rate. The reader can
work out for himself that the firm would have had t o invest the €750,000 to
yield at least 40% (the equity opportunity rate previously identified) to avoid
a fall in share price. Clearly, if it were possible, the adoption of the shareholder
opportunity cost approach could serve, over time, to maximise individual
share prices - which is exactly what one would have anticipated.

It is possible that the above illustrations are atypical because they are based on
an exceptional period. Merrett and Sykes’ (8) 1966 study implies otherwise.
Their results are summarised by the data in Appendix A and provide evidence
of continuing and large fluctuations in returns available from investment in
U.K. equities at different times. A different study by Barr (9) appears to
support rather than refute these conclusions so far as the U.K. is concerned.
Evidence concerning the annual monetary return to be obtained by investing
in the Standard and Poor’s Composite Index for all years from 1929 to 1972
is provided by Sharpe (10). He found a mean return of 10.64% with a standard
deviation of 21.06% and sizeable fluctuations in annual return occurred
throughout the period tested, so his data implies the existence of frequent
and marked revision of expectations by the U.S.A. market. It seems most
likely that very often the markets provide prices which are poor approxima-
tions of the actual future cash flows discounted at the rate of return
required by the market. The CAPM helps us to estimate the latter rate, and
conventional wisdom tells us that its use in capital budgeting will maximise
shareholders’ wealth.* This paper argues that such an outcome will only be
achieved if share prices,are adequate reflections of actual future cash flows
and expected rates of return, and that that is unlikely under the uncertainty
typically existing in practice. So it seems that the use of market expectations
derived figures of equity cost are unlikely to maximise shareholders’ terminal
wealth.

Under assumptions of perfect, frictionless, markets and homogeneous

expectations on the part of all market participants - including management -
it can be argued that current wealth in the form of share price can be
paximised by accepting all projects with positive net present values when
discounted at the market’s required rate for the systematic risk class involved.
Such an outcome would free the analysis from the restrictive assumption
Concerning homogeneous consumption preferences, identified in note 3, for
all shareholders could then choose either to hold or sell the investment

108 John R . Grinyer

represented by the project. A well known presentation of this type of approach
is to be found in Fama and Miller (12). This paper is based on the assumption
that expectations are not homogeneous so far as management and the market are
concerned, because delays occur in the communication of managements’
forecasts to the market and in the market’s acceptance of them (even if they are
correct). P.S.Albin (13) discusses this problem more fully. Markets are not,
therefore, assumed to be perfect in the manner described above, although they
can be “efficient” (in the sense that share prices reflect all publicly available
information) and encompass homogeneous investor expectations without
affecting the analysis. Failure of the market price promptly to reflect manage-
ment’s expectations seems sufficient to invalidate the current wealth-based
approach so the adoption of the “opportunity cost” basis outlined in this paper
merits serious consideration.

MANAGEMENT OBJECTIVES UNDER UNCERTAINTY

There is no evidence to suggest that managements are usually expert at predicting

the future movements in general share prices, and it seems likely that in such
matters their judgement is inferior t o that of professional investors.’ In practice,
then, operating under equivalent or greater uncertainty than the market, it may
be unwise for managements to assume that the market does not provide an
adequate measure of the worth of shares in general. If the decisionmaker wishes
to rnaximise shareholders’ wealth and has to assume that share prices are ‘correct’,
it is probable that he cannot do better than estimate the return anticipated by
the market when investing in equivalent risk equities, and use that as the cost of
equity capital. Our discussion has identified, however, that the cost of equity
figure so derived may not only be wrong because of the failure of the analyst to
correctly estimate the market’s required rate of return, but also (probably to a
much greater extent) because of the market’s failure to adequately forecast
future cash flows to be derived from holding shares.

Appendix B shows that, even if management could adequately estimate the

shareholders’ opportunity costs, it would still have to accept highly unrealistic
assumptions in capital project appraisals using maximisation of existing share-
holders’ wealth as the objective function. In practice, neither management nor
the market seems likely to be able consistently to estimate that opportunity cost
within an acceptable range of accuracy. Sizeable error may, therefore, exist at
two stages in the analysis and it seems likely that shareholders’ wealth will
usually be maximised more by luck than by judgement. This is an unsatisfactory
position. At the commencement of this paper, it was suggested that management
probably wishes to satisfice so far as shareholders’ interests are concerned and, as
the adoption of the maximisation of shareholders’ wealth proxy for such an
objective appears to fail, it seems sensible for management to restate its satisficing
requirement more directly in a form amenable to analysis without the difficulties

l’Xe cost of equity, the CAPM and tnanagement objectives 109

identified above. There are a number of grounds for selecting the provision to
shareholders of the market’s currently required rate of retum as the satisficing
criterion, e.g.

(a) It is presumably the rate which has been used in investor decisions
concerning investment in alternative markets, after taking account of required
compensation for the disutility of differential risk - and therefore probably
reflects opportunity costs in nonequity markets.

(b) One can argue that it should equal the marginal rate of time preference,
after compensation for risk-taking, of investors and therefore the firms’
shareholders (under the assumption that they are all currently investors rather
than borrowers). It should, therefore, help them to maximise the utility of
their consumption decisions over time if the rate is adopted.

(c) As it is the rate which they expect, provision of it should leave share-
holders reasonably satisfied and failure to provide it might create dissatis-
faction.

Following the above reasoning, we now define the objective of the firm as “the
maximisation of specified objectives, subject to providing shareholders with the
return which they would have required, at the date of expenditure of their funds,
from investments of equivalent risk”. This definition is compatible with a variety
of objectives, such as maximising the size of the firm, which can be viewed as
proxies for nonquantifiab1e.satisfactionsto be derived by participants in the
firm. A purpose of the project appraisal must now be to estimate the extent to
which considered projects meet the shareholders’ required return constraint. If
share prices were always good approximations of future cash flows and the rate
of return currently expected by shareholders from investments in the appropriate
risk class, the shareholder could sell his shares at any time to realise his expected
return. (Subject, of course, to the distorting effects of transaction costs.) In that
unlikely event, the market’s required return could be used with the satisficing
objective in capital budgeting without further assumptions. The real world
conditions of significant variability in share prices require, however, an additional
assumption to validate capital project appraisal techniques. Such an assumption,
now generally adopted in this paper, is that the firm’s existing shareholders will
hold their shares until the terminal date of the project, so that the firm could
distribute the total project net cash inflows to them. This relieves the analysis of
the problems deriving from ‘incorrectly’ priced shares. Within this framework,
the familiar discounted cash flow techniques can be used, subject only to their
well known limitations concerning reinvestment rates, with the selected criterion
rate.

110 John R . Grinyer

 ESTIMATING THE R E W I R E D RATE

Even if management adopts the satisficing objective, it has still tO estimate the
return required by investors from investments of the project’s risk class. Such
estimates require a model of market behaviour and, as discussed above, the
CAPM seems likely to be the most appropriate choice given the existing state of
knowledge. The latter, however, defines returns by reference to a single period.
(In practice “B’s” have usually been calculated for relatively short periods, e.g.
of one month’s duration.) Attempts to adapt the model to a multi-period setting”
often seem complex, requiring the input of data which is unlikely to be readily
estimated by management, yet not fully to utilise the information implicit in
current market data. Some improvement may be possible by simplifying the
procedure and recognising in the analysis the existence of a term-structure of
interest rates. The most casual observation reveals such a structure which, at any
point in time, yields different rates of interest for loans of different maturity. This
paper will not discuss the theories suggested to explain this phenomenon: it is
sufficient that it exists and has interesting implications for the use of the CAF’M,
e.g.

(a) a different ‘riskless’ rate may exist for each term (in this paper it is
assumed that it does) and

(b) for a long period, including a number of receipts of interest, the risk-less
rate can only be calculated under estimates of reinvestment rates during the
period; but such estimates are themselves presumably based on probability
distributions such that the rate is not ‘riskless’ after all!

Comment ‘b’ might be challenged on the basis that the interest rate is
contractually determined, so that it must be riskless. Such reasoning could
proceed by defining the rate as iIT in equation 3.

where i is the interest payable as a proportion of the amount borrowed,

B is the amount borrowed,

itT is the compound interest rate actually received by the investor for a loan
of T periods,
M is the amount paid to the investor on maturity, and
T is the period at the end of which the ioan is repaid.

As all other terms are contractually agreed, iIT is also contractually agreed and
can be viewed as risk free. The CAPM is a single-period model, however, so the

The cost of equity, the CAPM and nianagenient objectives 111

T-period ‘risk-free’rate must surely require forward contracts for onward lending
of future returns, i.e. it is i 2 in~ equation 4.
T T
Z iB ( I1 (1 +ijn,)+M
o= n = t=n+
1 ti2T
-B (4)

where i3nt is the reinvestment rate in period t for the cash inflow in period n,
noting that the investor may face a different term structure of rates in each
period n.
i 2 is~the single period rate which solves the equation and other terms are as
previously defined.
T
I1 means multiplying the following expression (T-n) times, with the
t=n+1
variables taking on the assigned values.

Only if i3,,t was contractually set at the outset of a transaction, could it be

regarded as riskless, so a riskless rate for a multi-period term seems unlikely to
exist. Nevertheless, the CAPM seems likely to be useful for estimating required
returns, so further analysis is necessary to identify the assumptions implied by its
use for that purpose. If we substitute (1 + i 2 ~ 0in) Equation
~ 4, where i 2 ~ is
0
the periodic rate such that 1 t i 2 =~(1 + i ~ ~ o and ) ~assume
, that ijnt equals
i 2 p for all periods, we find that Equatioq 4 converts to the form of Equation 3,
such that i 2 ~ 0= iIT. We are unlikely to be able adequately to forecast ijnt, so we
might just as well assume that it equals iIT and use the latter equation, which has
the advantage that it seems more compatible with accepted thinking and
evaluation methods. This step is, however, based on judgement and convenience
and many alternatives may be defended on the same grounds.

Assuming that ijnt equals iIT, we can define the single-period “riskless’ rate of
return for a T-period term, h ~as ,

Insertion of this in equation 1 then gives a required return (over the T-period
term for a project of systematic risk class j) of

%If = i4T BjT(RmT - hT) (6)

where B ~ Tis the B for systematic risk j and a T-period term,
R,,,T is the expected market return for a term of T-periods
%jT is the single-periodreturn expected for a T-period term and systematic

112 John R. Grinyer

 risk class j, and other symbols are as previously defined.

The reader will not that our analysis is still in the form of a single-period model.
Now defme R * 4 ~as j the periodic rate of return such that

Projects would meet the estimated required rate of return, defmed in equation 6,
if

which can be shown as

where I is the amount of the investment in the project,

C, is the project cash flow in period n
rnt is the return in period t of investments (at equivalent systematic risk) in
period n, and other terms are as previously defined.

If we assume that rnt = R*4Tj for d periods, equation 9 converts to

which is the ”V calculation.

We have, then, identified that we can validly use the multi-period rate R * 4 ~inj
Nw calculations under the assumptions
(a) that the reinvestment rate on periodic payments on ‘riskless’ T-term
securities is constant and equals the geometric mean of the single-period
return (after reinvestment) less one - i.e. that
-I
i 3 n t = ( I +izT)T- 1 for allyears
- so that the ‘riskless’ T-term rate is fully defined by contractual flows, and
The cost of equity, the CAPM and management objectives 113
 (b) that the rate of return available on reinvestment in systematic risk class
j, of cash flows generated by projects of that risk class, is the same as the
selected discount rate - i.e. that rnt = R * 4 ~ for
j all periods.

These assumptions are unrealistic, but may provide as plausible a set of values as
can be produced by management forecasts. If that is the case they would appear
to be acceptable as a basis for practical decisions, when the NPV criterion rate
can be estimated using equations 6 and 7, i.e. it is
1
i4TF - 1

Obviously the estimates of many of the variables in the equation are likely to be
wrong - but this may still be the best approach available! The variables 4~ and
R m can ~ be estimated from data concerning present and past market transactions.
B ~ Tis more difficult to estimate because it is observed that the B applied by the
market to a firm’s shares changes over time. (W.F. Sharpe and G.M. Cooper have
provided an interesting paper on this topic, (16).) A natural starting point for
estimating B for a capital project may be the B’s calculated as applying to the
firm in the past. Management could then determine some rules to enable it to
adjust B, for project assessment, by reference to the perceived project risk class
(e.g. a replacement project in the firm’s major line of business might be assigned
the firm’s B). This procedure seems crude, but an even less satisfactory approach
has usually applied in the past, when no specific recognition has typically been
given t o systematic risk. Adoption of the assumptions specified earlier would
then allow the derived discount rate to be validly used in the furtherance of the
shareholder satisficing objective.

CONCLUSIONS

This paper claims that in the oncertain market environment the maximisation of
shareholders’ wealth is likely to be only achievable by luck and not by judgment,
because highly unrealistic assumptions, concerning both the market and the
individual shareholder’s alternative investment, are then necessary to the valid
use of the expected market rate of return with discounting models. The
maximising objective conventionally advanced in the literature of financial
management, therefore seems inappropriate as a proxy for the satisficing of
shareholders’ interests. An alternative, directly satisficing, aim is to provide
shareholders with the return which they require at the date of the investment,
i.e. the market’s expected rate of return. Such an approach seems fully consistent
with the concept of multiple corporate objectives and to require less unrealistic
assumptions than the wealth maximisation model when using capital project
evaluation methods. The analysis of the paper suggests a capital budgeting
application of the concepts of the CAPM whch recognises the term-structure of
interest rates when estimating the required rate of return for multi-period projects.

114 John R. Grinyer

Almost inevitably this paper poses more problems than it solves. It has, however,
developed a line of analysis which may prove relevant to the current business
environment and lead to new directions for the development of theory: for
example, it seems likely that an original and relevant departure from received
wisdom W III from the application of the satisficing model in a geared firm.
result

NOTES

E.g. see Bogue and Roll (3).

The conclusions of the paragraph are supported by extensive analysis, which

will not be outlined here but can be found elsewhere, e.g. in Grinyer (5).

This implies homogeneity of shareholders’ consumption preferences, to the

extent that they are all assumed to prefer consumption on or after the terminal
date of the project, which is clearly unrealistic. It appears that any approach
to analysis in this area requires the adoption of dubious assumptions, and in
the end choice between alternatives depends upon the reader’s judgement as
to which assumptions are most acceptable.

This is a potentially confusing point, because we are including risk premiums

in a world of certain returns. Redefine the slope of lines such as LLI as the
market’s expected rate of return, then, under an assumption of ‘correctly’
priced shares, the lines in figure 1 are correct in the sense that they correctly
predict the consumption possible in period 1 by present investment in
monetary assets. But under uncertainty investors would not know that, and,
assuming that they are risk averse, they would require compensation by way
of a risk premium for the disutility of risk bearing. On this basis risk premiums
can be perceived as the price paid for the acceptance of such disutility, which
concept must surely be reasonable since we would on a conventional analysis
eipect an investor who was indifferent to risk, to discount the expected values
of fKture cash flows at the riskless rate of interest, for the acceptance of risk
creates no disutility for him.

A summary of the basic literature on the CAPM is to be found in Jensen (6).

See Jensen (6) for a summary of the early work.

See Rubinstein (7) for a discussion of the assumptions.

See Van Horne (1 1) for a well known exposition of this view.

As they appear to consider that the timing of issues of equity is important,

however, it appears that in practice managements do act on the assumption

The cost of equity, the CAPM and management objectives 115

 that they know better than the market. There is, of course, strong academic
backing for the hypothesis that the markets are efficient in the sense that they
promptly reflect available information, see Fama (14) for a summary, which
supports the view that managers are unlikely to be better predictors of general
movements, than is the market.

lo E.g. See Bogue and Roll (3) and Bieman and Smidt (15) for discussions on the
application of the CAPM to multi-period capital project appraisal.
REFERENCES

REPORT OF THE STUDY GROUP ON THE OBJECTIVES OF

FINANCIAL STATEMENTS, New York, A.I.C.P.A., 1973.

THE CORPORATE REPORT, a discussion paper published by the U.K.

Accounting Standards Steering Committee, August 1975.

M.C. Bogue and R. Roll, ‘Capital Budgeting of Risky Projects with

“Imperfect” markets for Physical Capital’, JOURNAL OF FINANCE, 29,
May 1974.

H.A. Simon “On the concept of Organisational Goal”, ADMINISTRATIVE

SCIENCE QUARTERLY, 1964.

J.R. Grinyer, “An Extension of Fisher’s Model” JOURNAL OF BUSINESS

FINANCE, Spring 1973.

M.C. Jensen, “Capital Markets Theory and Evidence”. In STUPIES IN

THE THEORY OF CAPITAL MARKETS, Praeger Publishers, 1972.

M.E.Rubinstein, “A Mean-variance Synthesis of Corporate Financial

Theory”, JOURNAL OF FINANCE, March 1973.

AJ. Merrett and A. Sykes, “Return on equities and fured interest

securities: 1919-1966”, DISTRICT BANK REVIEW, No.158, 1966.

N. Barr, “Real Rates of Return to Financial Assets since the War”, THE
THREE BANKS REVIEW, September 1975.

W.F. Sharpe, “Likely Gains from Market Timing”, FINANCIAL

ANALYSTS JOURNAL, MUch-April 1975,

J.C. Van Horne, FINANCIAL MANAGEMENT AND POLICY, 3rd edition,

1974. Prentice Hall Inc.

116 John R. Grinyer

(12) E.F. Fama and M.H. Miller, THE THEORY OF FINANCE, Holt Rinehart
and Winston, 1972.

(1 3) P.S.Albin, “Information Exchange in Securities Markets and the Assump-

tion of Homogeneous Beliefs”, JOURNAL OF FINANCE, 29, September
1974.

(14) E.F. Fama, “Efficient Capital Market: A review of Theory and Empirical
Work”, JOURNAL OF FINANCE, March 1973.

(15) H. Bierman and S. Smidt “Application of the Capital Asset Pricing model
to Multi-period Investments”, JOURNAL OF BUSINESS FINANCE AND
ACCOUNTING, Autumn 1975.

(16) W.F. Sharpe and G.M. Cooper, “Risk-Return Classes on New York Stock
Exchange Common Stocks, 1831-1967”, FINANCIAL ANALYSTS
JOURNAL, March-April 1972.

APPENDIX A

Returns from investment of lump sums in a U.K. stock exchange index in each
of years 1919-1956, each investment being held for ten years.
MC :Y TEI IS RE L TEN 1
YEARS 1919-29 130-45 946-56 9 19-2s 9 3 0 4 1946-56
Mean return 8.8% 5.5% 10.4% 11.4% 1.3% 6.2%
Standard devia-
tion of return 2.8% 2.8% 3.9% 4.0% 2.9% 4.4%
Range of return 2.9% 3 .O% 4.4% 3.6% - 1.9% -0.7%
to to to to to to
13.2% 0.5% 14.6% 17.2% 7.9% 11.3%
Greatest differ-
ence in return
from invest-
ments in
succeeding years 5.4% 4.4% 5.5% 6.3% 3.3% 5.5%
Proportionate
change in return
represented by
(d) above - i.e.
’d’/preceding
year’s rate 0.4 0.7 0.6 0.6 0.4 1.3

The cost of equity, the CAPM and management objectives 117

 Source
Observations taken from data listed in AJ.Merrett 8c A. Sykes, “Return
on equities and fixed interest securities: 1919-1966”. District Bonk
Review. No. 158 (1966)

An increase in the volatility of the measured return could be expected t o appear

as the notional holding period was shortened from 10 years, and Merrett and
Sykes’s analysis of the results for a one-year holding period confirmed that
expectation, with real and money returns fluctuating dramatically from below
- 10%in 1956 to over +40% in 1957.
APPENDIX B

MAXIMISING SHAREHOLDER WEALTH WITH KNOWN RATES OF

RETURN TO ALTERNATIVE INVESTMENT

This appendix identifies assumptions under which the use of net present value
techniques to maximise shareholders’ wealth, would be valid if management
operated under certainty concerning the rate of return, to shareholders, from
investment alternative to that available in the firm. We proceed by assuming: -

1) That existing equity holders will immediately invest elsewhere on the

national equity markets, in shares of comparable risk, if their funds are not
invested in the firm in which they currently hold shares and that management
knows the rates of return which will actually be realised on such investments.

2) That the term of the shareholders’ alternative equity investment will be the
same as that of the project under consideration by the firm, and that they will
reinvest intermediate cash flows prior to the terminal date.

3) That reinvestment rates available t o the shareholder and the firm are the
same.

4) That there are no transaction costs.

5 ) That all cash flows occur at the end of the periods involved.

6) That managers have the sole objective of maximising existing shareholders’

wealth at the terminal date of the project, and that existing holders will
retain their shares until that time.

Under these assumptions the rate of return which the shareholder would obtain
on the investment alternative to a capital project would be “r” in equation 2
below

118 John R . Grinyer

 n
where I1
, means multiply the following expression
J=t+1
(n- t) times with i taking the value for period j
n is the terminal period of the capital project
Po is the present share price of the alternative
At is the cash flow at time t derived from the investment
and ij is the rate of interest during period j.

This equation defines the shareholder’s average annual return from the alternative
investment as the discount rate which equates the terminal value of the cash flow
associated with that investment with its present price. It will be noted that the
size of the rate “r” depends on the future rates of interest available, the size of
the cash flows (including present share price) and also the timing of those flows.

The average annual return actually obtainable from holding the alternative
investment is ‘rl ’ in the Equation A2.

where m is the period of sale of the share

P, is the price obtained on the sale and other terms are as defined in
Equation A1 .

Thus the shareholders’ opportunity cost is a function of the stream of cash flows
actually resulting from holding the alternative investment, and its present share
price.

The rate ‘r, ’ will only be constant for all shareholders if they all sell the identical
alternative investment at a common date, unless share prices are always an
adequate reflection of the future cash flows to be derived from holding the
shares and the future interest rates. They are unlikely to be such a reflection, so
a model which is based on an acceptance of share sale at different dates requires
assumptions which are as unreahstic as that of sale of shares at a common date,
and the latter seems tenable as the basis for analysis. This paper assumes that the
alternative investment would be sold at the terminal date of the capital
expenditure project, so that P, becomes A, and equations A1 and A2 are
equivalent. We continue on the basis of A l .

The cost of equity, the CAPM and management objectives 119

The use of the opportunity cost rate 'r' to derive Net Present Values ("Vs) will
only generally be correct, in the absence of further assumptions, if the period
reinvestment rate 'ij' equals 'r' for all periods. This can be seen from the following:

let ij = r for all periods, then A1 converts to

Po =-
(1 t r)"
E
t=1
At (1 t r ) n - t

a capital project will appear to be acceptable when evaluated at discount rate '?
if

where I is the immediate outlay on the project (which is assumed to be equal

to Po)
Ct is the flow associated with the project in period t and other terms are as
previously defined.

Equation A4 could be rewritten as:

But I=Po, so it can be shown as

i.e.

Therefore, if the Net Present Value of a project is positive or zero, at discount

rate 'r', and the reinvestment rate is also 'r', its terminal value will exceed or equal
that of the alternative investments and the project is acceptable on financial
grounds under the assumptions of this analysis. Conversely, if the Net Present
Value is negative the project is not acceptable.

As the required assumption of constant reinvestment rates is inappropriate to the

realistic situation of changing interest rates, alternative analyses should be

120 John R . Crinyer

considered. For example, a possible approach is to assume, in addition to
assumptions 1 to 6 above, that the potterns of the future cash flows of the
project and the shareholders’ alternative investment are identical (although the
flows can naturally differ in size) and that all future flows will be non-negative.
The discount rate to be used in capital budgeting as a reflection of shareholders’
opportunity cost can then be defined as the rate which discounts the cash flows
associated with the shareholders’ alternative investment to the initial outlay on
that investment, i.e. it is ‘d’ in Equation A6.
” At
P0=C -
t = l (1 t d)t

Use of ‘d’ would signal acceptance of the capital project if

But Po equals I, so that on the stated assumptions At < Ct in each period if the
project has a positive or zero net present value at the discount rate ‘d’. In that
case, the terminal value of the project must be greater than, or equal to, that of
the shareholders’ alternative investment, regardless of the reinvestment rates
available, which are assumed to be identical for the shareholder and firm.
Similarly, a negative net present value will indicate that the project has a lower
net terminal value than the alternative, regardless of the reinvestment rates.
Although a correct accept/reject decision would emerge the NPV is not
necessarily a meaningful figure, however.

The above analysis highlights a number of points apparently overlooked in much

of the literature. Even under the unrealistic assumptions 1 to 6 above, to use
NPV analyses to maximise shareholders’ terminal wealth, management must
further assume that either (1) reinvestment rates will not change and will equal
the equity holders’ present opportunity cost or (2) the alternative investments
will generate identical patterns of cash flows, to identical terminal dates, to
those of the capital projects. Under (2) reinvestment rates become irrelevant to
the accept/reject signal if those rates are identical for the firm and the share-
holder, but the NPV figures derived may not be meaningful statements of value.
It appears that the adoption of a shareholder wealth-maximisation objective
requires some highly unrealistic assumptions, even if management is certain about
the alternative shareholder investment opportunity costs!

The cost of equity, the CAPM and management objectives 121