Capital Asset Pricing Model (CAPM)

Normally the company’s cost of capital is used to discount

the forecasted cash flows of the new project. Many
companies estimate the rate of return required by investors
in their securities. Towards this purpose the company’s
cost of capital is used to discount cash flows in all new
projects. This is not an accurate method since the risk of
existing assets of a company may differ from the risk of
new project assets. Since investors require a higher rate
of return from a very risky company, such a company will
have a higher discount rate for its new investment
opportunities. The cost of capital or required rate of return
on the project would be the same as the one on company’s
existing assets if the risk is the same. The company’s cost of
capital is the correct discount rate for projects that have
the risk as the company’s existing business. If the project
risk differs from the risk on existing assets, the project has
to be evaluated at its own opportunity cost of capital.
The true cost of capital depends on the use to which it is put.
2. The CAPM can be used for estimating the company’s
cost of capital. Each project should be evaluated at its own
opportunity cost of capital. Capital asset pricing policy
theory tells us to invest in any project offering a return that
more than compensates for the project’s beta. Beta is a
measurement of the amount that investors expect the stock
price to change for each one percent additional change in
the market risk. The discount rate increases as project beta
increases.
3. However, firms require different rate of return from
different categories of investment. The higher the beta risk
associated with an investment, the higher the expected rate
of return must be to compensate investors for assuming
risk.
4. The CAPM holds that there is a minimum required rate
of return even if there are no risks, plus a premium for all
non-diversifiable risks associated with investment.
Projects should be evaluated as portfolio and there is a
reduction of risk when they are so combined.
5. For calculating the company’s cost of capital, the beta
of its assets has to be ascertained. But the beta cannot be
plugged into the capital asset pricing model (CAPM) to
find the company’s cost of capital because the stock
reflects both business and financial risk. The beta has to
be adjusted to remove the effect of financial risk since
borrowing increases the beta (and expected return) of its
stock.
6. The expected rate of return calculated from the capital
asset pricing mode
r = r f + β ( rm - r f )
(where r is discount rate, rf is interest rate on risk free
asset like treasury bill and rm is expected return) can be
plugged into standard discounted cash flow formula
as under:
 T t T t
PV Σ C / ( 1+ r) = Σ C t / [ 1 + rf + β ( rm – rf ) ]
t=1 t=1

The capital asset pricing model values only cash flow for
the first period (C1). Projects, however, yield cash flows for
several years. If the risk adjusted rate r is used to discount
the cash flow, we assume that cumulative risk increases at
a constant rate. The assumption will hold when the
project’s beta is constant or risk per period is constant.
2. Capital Allocation Framework(CAF)
Capital budgeting is not the exclusive domain of financial
analysis and accountants. It is multifunctional task linked
to a firm’s overall strategy.
Capital is scarce and hence must be allocated across
competing claims very judiciously. The identification,
evaluation, and selection of individual investment proposals
is usually guided by a capital allocation framework, defined
explicitly or implicitly by top management.
 The CAF of a firm spells out the kinds of businesses the
firm wants to be in, the strategy of the firm, the types of
investments that make sense for the firm, the approach of
the firm towards conglomerate diversification, so on and
so forth.
CAF is divided into seven sections as follows:
 Key criteria
 Elementary investment options
 Portfolio planning models
 Strategic position and action evaluation
 Diversification debate
 Investment in capabilities
 Strategic planning and capital budgeting
2.1 Key Criteria
The objectives of maximizing the wealth of
shareholders is reflected, at the operational level, in three
criteria: profitability, risk, and growth.
 • Profitability is defined as: Profit after tax
Net worth
• Risk: It reflects variability. How much do individual
outcomes deviates from the expected value? A simple
measurement of variability is the range of possible
outcomes
i.e. the difference between highest and lowest outcomes.
• Growth: It is manifested in the increase of revenues,
assets, net worth, profits, dividends, and so on. To reflect
the growth of a variable, the measure commonly employed
is the compounded rate of growth.
2.2 Elementary Investment Options
The building block of the corporate resource allocation
strategy are the following elementary investment options:
 Replacement and modernization
 Capacity expansion
 Vertical integration
 Concentric diversification
 Conglomerate diversification
 Investment Options
Investment Principal Likely Outcomes
Strategy Motivators Profitability Growth Risk
Replacement -Quality improvement High Moderate Low
&modernization - Cost reduction
- Maintenance
Capacity -Ability to serve High Moderate Moderate
Expansion growing market
- Cost leadership
Vertical -Greater stability for High Moderate Moderate
Integration existing and proposed
operations
- Greater market power
Concentric - Improves utilization High Moderate Moderate
Diversification of resources
Conglomerate - Limited scope in the Moderate High Low
Diversification present business
Divestment - Inadequate profit High Low Low
- Poor strategy
Elementary Investment Strategies, Principal Motivations, and likely
Outcomes
2.3 Portfolio Planning Models
To guide the process of strategic planning and resource
allocation two tools have been quite relevant. They are
o BCG Product Portfolio Matrix
o General Electric’s Stoplight Matrix
Boston Consulting Group (BCG) matrix analyses products on
the basis of (a) relative market share and (b) industry growth.
BCG Product Portfolio Matrix
Relative Market Share
Industry Growth high Low
Rate
High Stars Question
marks
Low Cash Dogs
cows

 Stars: Products enjoying a high market share and a high

growth rate are referred to as stars
 Question marks: Products with high growth potential but
low present market share are called question marks
 Cash cows: Products which enjoy a relatively high market
share but low growth potential are called cash cows.
 Dogs: Products with low market share and limited growth
potential are referred to as dogs.
It is clear that cash cows generate funds and dogs, if divested
release funds.
GE’s Stoplight Matrix:
It is for the sophistication, maturity, and quality of its
planning systems.There are two key issues:
(a) Business strength - How strong is the firm against
competitors?
(b) Industry attractiveness – What is the attractiveness or
potential of the industry?
As shown in the following exhibit, products which are
favorably placed justify substantial commitment of funds and
those unfavorably placed call for divestment.
 Business Strength

Strong Average Weak

High Invest Invest Hold

Industry Medium Invest Hold Divest
Attractiveness Low Hold Divest Divest
Products which are placed in between qualify for divestment.
2.4 Strategic Position and Evaluation (SPACE)
SPACE is an approach to hammer out an appropriate
strategic posture for a firm and its individual businesses.
It involves a consideration of four dimensions:
 Company’s competitive advantage
 Company’s financial strength
 Industry growth
 Environment stability
In order to apply SPACE approach to a firm, the
following procedure may be followed:
 1. Numerically assess the firm on the factors which have a
bearing on four dimensions. The scale of assessment for the
factors relating to the dimensions of company’s financial
strength and industry strength may be 0 to 7, with 0
reflecting most unfavorable assessment and 7 the most
favorable. However, the scale of assessment for
environment stability and competitive advantage may be
o to –7, with 0 reflecting the most favorable and –7 the
most unfavorable assessment.
2. Plot the scores for four dimensions on the axis of the
SPACE chart.
3. Connect the scores so plotted to get a polygon, reflecting
the size and direction of the assessment. (Refer the chart)
Strategic Postures : A. Aggressive
B. Competitive
C. Conservative
D. Defensive
A. Aggressive posture B. Competitive Posture
FS 7 FS 7

-7 7 -7 7
CA IS CA IS

ES –7 ES –7
C. Conservative Posture D. Defensive Posture
FS 7 FS 7

-7 7 -7 7
CA IS CA IS

ES –7 ES -7
 Generic Strategies and Key Options
Concentric
Status Quo FS Diversification
Conglomerate
Diversification Concentration
FOCUS COST
LEADERSHIP
Vertical
Diversification Conservative Aggressive Integration

CA IS
Divestment Defensive Competitive Concentric
Merger
GAMESMAN- DIFFEREN-
Liquidation SHIP TIATION Conglomerate
Merger

ES
Retrenchment Turnaround
2.5 Diversification Debate
Conglomerate diversification, which is involves
diversification into unrelated areas, is very common in
India. Despite its popularity, it is considered to be a highly
controversial investment strategy.
1. Most of the businesses are characterized by cyclicality.
It is desirable that there are at least two to three distinct
lines of business in a firm’s portfolio. It helps a company
in reducing its overall risk exposure.
2. It expands opportunities for growth. When the existing
business reaches saturation it is natural to look at other
businesses where growth opportunities exist. While the
prospects of succeeding in the new line of business are
often uncertain, the immense potential acts as an
irresistible bait.
3. Though a good device for reducing risk exposure and
widening growth possibilities, conglomerate diversification
more often than not tends to dampen average profitability.
Guidelines for Conglomerate Diversification
Conglomerate diversification, in general, dampens
profitability and in some cases jeopardizes the existence of
the firm.There are some practical guidelines in this respect:
1. If you lack financial sinews to sustain the new
project during the ‘learning period’, avoid
grandiose diversification projects.
2. Realistically examine whether you have the critical
skills and resources to succeed in the new line of
business.
3. Ensure that the diversification project has a good fit
in terms of technology and market with the existing
business.
4. Try to be the first or a very early entrant in the field
you are diversifying into. This will protect you from
serious competitive threat in the initial years.
5. Where possible, adopt the following sequence:
marketing-sub – contracting – full manufacturing.
 6. Seek partnership of other firms in areas where you
are vulnerable or competitively weak.
7. If the failure of the new project can threaten the
company’s existence, float a separate company to
handle the new project.
8. Remember that meaningful conglomerate
diversification represents the greatest challenge to
corporate vision and leadership.
9. Guard against bandwagon mentality and empire-
building tendencies.
2.6 Investment in Capabilities
Empirical evidence suggests that companies that perform
well have organizational capabilities that enable them to
exploit opportunities. Organizational capabilities are
combinations of human skills, organizational procedures
and routines, physical assets, and the systems of
information and incentives that improve performance
along particular dimensions. Such capabilities are indeed
organizational assets. There are five specific capabilities:
 External Integration Capability
 Internal Integration Capability
 Flexibility
 The capacity to Experiment
 The capacity to Cannibalize
Allocating Resources to Build Capabilities:
 Identify the capabilities that the firm should develop
and ensure that there is a firm organizational
commitment to them.
 Develop a capital budget for capabilities and a
proper system of authorization and accounting for
expenditures relating to capabilities.
 Translate the desired capabilities into appropriate
goals and rewards that are clearly understood and
used by people throughout the organization.
 Link compensation of managers to improvements
in speed, quality, and flexibility.
2.7 Strategic Planning and Capital Budgeting
Capital expenditures, particularly the major ones, are
supposed to sub-serve the strategy of the firm. Hence, the
relationship between strategic planning and capital
budgeting must be properly recognized. The following
exhibit presents a way of defining this relationship. As
emphasized in the exhibit, capital budgeting should be
squarely related to corporate strategy.
The challenge for a company lies in developing a capital
allocation system which accommodates investment in
capabilities without sacrificing the benefits of a formal
financial analysis.
Environmental Managerial Vision, Corporate
Assessment Values & Attitudes Appraisal

Strategic Plan

Capital Product Strategy,

Budgeting Market Strategy,
Production Strategy
and so on