The Validity of Capital Asset Pricing Model Assignment Sample

• Subject Name : Accounting & Finance

Investment Appraisal and Valuation

1. Estimation of the cost of capital in 2015, for British service company, Royal Mail plc is the key issue at hand for Royal Mail. Cost of capital had become a problem because if two major reasons. Firstly, it was seen that since the privatisation, government based decision making was increasingly shed by the Royal mail for a more market based orientation. The managers do not set the cost of capital, as a market based measure, rather it is set by the investors.

Government regulators, Ofcom and Royal mail, after 500 years if government ownership, were trying to private their ownership. Secondly, it was an experiment in Britain to deregulate the private postal services. However, due to the recent events of competition, the government regulators were trying to re-evaluate existing regulatory policies.

To ensure proper assessment of the profitability of the overall operations of an organisation, an appropriate benchmark by managers is to estimate the cost of capital of a firm. Cost of capital can be defined as a return that is provided to the capital provider who forgoes an investment in some other project or asset with the same level of risk. This is the reason it is often known as the opportunity cost of capital. It is required that the managers must invest in the projects that yield greater returns than the cost of capital. This is because the investors want to get the minimum return which is the cost of capital.

If the organisation wants to know its return from all its projects, evaluating the cost of capital of that organisation is very significant. A capital budgeting is required whenever an organisation wants to decide on accepting a project. An organisation in capital budgeting must evaluate the relevant cash flows and then discounting them. The project should be taken when the net present value (NPV) is positive.

To estimate the net present value (NPV), it is generally seen that in corporate finance, the cost of capital is used as a discount rate. Needless to say, the cost of capital is same as the required return on the overall organisation or discount rate. For example, the net present value (NPV) will be positive only in the case when its return exceeds the required return, say, 10 per cent. It is important that the organisation must earn at least 10 per cent on the investment. This is to compensate the investors of the firm for using the capital to financial the project. Therefore, this is the sole reason we could say that the coast of capital that is associated with the investment is 10 per cent.

Cost of capital is the mixture of cost of equity and cost of debt. Thus, it would also be a mixture of the returns that are required to compensate the creditors and stakeholders of the firm.

According to me, the cost of estimation based on Kyle Brooks in Exhibit 6 is totally wrong. The interest expense that the organisation is currently paying has been used as the cost of debt by Brooks. But it is known that the coupon rate is equivalent to pre- tax cost of debt. The issue with the approach is that it ignores the current situation in the market which is pertinent to the current investors.

Based on the prevailing rates, it is a better approach to evaluate what the investors currently need. One of the methods is to evaluate on Royal Mail long term bonds the prevailing yield to maturity (YTM). One can evaluate the prevailing yield to maturity (YTM) at 3.6548 per cent using the bond which currently trade at a price of 106 (Griffith and Chandy,1986).

An alternative approach can also be used where the prevailing yields for bonds of similar credit ratings are used. BBB is currently used as the bond rating on the bonds of Royal Mail as per the case of Exhibit 6. BBB is considered to have enough capacity to make payment of interest as well as repayment of principal. BBB rated bonds are correcting yielding 3.776 per cent as per the case of Exhibit 8. Thus, for Royal Mail, both the evaluations could be applied as a reasonable estimate of the cost of debt (Hand et al., 1992)

Current dividend yield is used for estimation of the cost of equity in Exhibit 6 for Royal Mail. The major drawback of using this estimation method is that it does not consider the dynamic growth by taking into account the expected appreciation in stock price or dividends in its calculation. Thus, according to me Brook must use a security market line (SML) method. The capital asset pricing model (CAPM) approach can also evaluate the expected return on the equity of Royal Mail. The reason behind this is that security market line (SML) approach is used to the organisation rather than just those with steady growth in dividend. It also takes into consideration the sensitivity of the asset to the market while estimating the expected return (Kisman and Restiyanita, 2015).

Also, as per my opinion, the current 10 year government bond yield of 2.03 per cent should be used by the Brook for the risk free rate. The reason behind not using that 5 year government bond yield us that it is not a long term bond. Moreover, the 5 year government bond yield fails to take into account the inflation expectations of the long term debt. Therefore, according to me, a better approach is to use a 10 year rate. A beta estimate of 0.65 is used in the approach in Exhibit 6. For a postal company like Royal Mail, a value which is much below than zero would be consistent with their expectations of the risk profile. For the comparable companies in Exhibit 9, the beta estimate of 0.65 looks comparable.

When the risk free rate is equal to 2.03, beta estimate is equivalent to 0.65 and the recommended market risk premium is equal to 5.8 per cent then the cost of equity for Royal Mail would be equivalent to 5.8 per cent.

Cost of Equity = 2.03 % + (5.8 % × 0.65) = 5.8 %

Brook has used the book values for the weights of debt and equity. Using book values for the calculation would have led to underestimation of cost of capital because of underestimating the equity. As per my opinion, market value should be used instead of book values for the calculation of debt and equity weights. The reason behind using the market value is that the concern is to evaluate the amount it would cost a firm to raise the capital today. That particular cost is not associated by the book or accounting values but it is estimated by the market value of capital of the company.

It is known that for equity, the book values are not reliable to reflect market values. On the other hand, for debt, book values generally approximate market values. Therefore, using the current share price of Royal Mail of 511 pence and outstanding shares of 1 billion, the calculation of the market value of equity is equal to 5110 billion. Market value of debt turns out to be 963 billion. 15.86 per cent and 84.14 per cent are the weights for debt and equity respectively by using these values.

2. One of the largest life- sciences dedicated venture capital companies was Vine Brook Capital (VBC). The firm was founded in 1994 and was based in Lexington, Massachusetts and Menlo Park, California. The company, Vine Brook Capital (VBC) specialised in number of services such as:

• Late stage investments in medical devices
• Health care information technology
• Biotechnology and pharmaceuticals
• Health Care services

Hardina Smythe was given the opportunity to accept one offer among the there job offers. She had decided to accept the position at Vine Brook Capital (VBC). The first work that she was assigned from Clifford Cliff Stone who was legendary senior partner of Vine Brook was to assess the three potential health care investments.

The three potential investments provided to Hardina were a cross study of the health care industry. All the three deals of investment addressed varied segments of the market which ranges from health care information technology to biotechnology development and ultimately a medical device firm. However, there were differnt strengths in all the three investment proposals in spite of the diversity. The distinct strengths of the all three potential investment proposals highlights that it depends on the company to consider what are the requirements which actually need to be look after first. The three potential investment proposals were:

• AlwaysCovered Software
• BioChallengers, Inc
• Sweet dreams Technology

The time Hardina joined was the year of 2010. It has been tumultuous for the venture capital (VC) companies from the last decade. The first part of this decade is when the firms were recovering from the burst of the Internet and Telecom bubbles. There was stubbornly lag in the fundraising behind the anomalous peak of 2000 of $158 billion. In 2009, there was a decline of 47 per cent of dollars in fundraising. There was combined burden of plunging capital markets as well as economic recession in 2008. At the end of 2009, there were only 63 companies that gone to the market because of the effect of global financial crisis.

It was for the first that that in 2009, organisations began to focus more on the healthcare out placed investment in IT and health care sector. It was expected that venture capital investment in health care and technology would rebound after the recovery in economy, but there were few companies who witnessed return to the levels of 2007. The difficult environment for fund raising and the stagnation in the IPO market led the investors of the venture capital to be more cautious in investing in health care. They became more focused on making their investments cost effective.

In the paper by Gompers at el. (2018), they surveyed institutional venture capitalists (VCs) at 681 organisations to know the way they make decisions. The paper provide detailed information on the practices of venture capitalists (VCs) in pre investment screening, in structuring investments and also in post investment monitoring and advising. It was observed that while selecting investments, the venture capitalists (VCs) find the management team as one of the significant factor to consider. It is also noted that that venture capitalists (VCs) attribute the final success or failure in the investment to the team. Thus, they attribute more to the team rather than to the business for the success or failure of ultimate investment. Although it is seen that there is cross sectional variation across firm stage and industry, still business related characteristics, for example, product or technology are not considered more important than management team.

According to my opinion, during this period of time the only requirement of Vine Brook is to have a good management. Therefore, the company, Vine Brook should invest in the proposal of AlwaysCovered software. The product delivered is a scheduling tool over the internet through a web interface. There are many plus points of investing in this software as compared to other two proposals. The very first benefit is that it would lead to reduction in the reliance on outside staffing solutions that are temporary and costly. Thus, AlwaysCovered addresses the problem of hospitals and health care providers of costly staffs. It provides a guide on how to maximise the staffing of nurses and other health care professionals. AlwaysCovered was based on Minneapolis and had 22 full time employees.

It is noted that the average that hospitals spent on filling shifts with the help of contract nurse agencies is 3 million dollars a year. The software of AlwaysCovered help the hospitals to build and manage an audit based registry. This internal registry allows the nurses and other medical staffs to bid on shifts/ positions that are open according to their qualifications. This application provides opportunities to internal staffs and administrators and a greater system that gives a view of the shortages in staffs. This also minimised the requirement to use costly outside agencies.

It was seen that software of AlwaysCovered was successful in use by 2010. This software was used by four medium sized hospital groups. The reviews given by the staffs and management were very positive. There was a deep pipeline of top tier customers for AlwaysCovered. It was clear that AlwaysCovered had an advantage of first to market. The team of the company was an all star collection of knowledgeable entrepreneurs. The experts of the team was operating on leveraging its relationships to build as many strategic alliances with top corporations. This was in line to expand the technology of AlwaysCovered. The installation fees of this software is also small due to economies of scale. There is a potential of growth in other markets as well. The investment made in this software is relatively small.

However, there were other two proposals that also had some strengths which needs to be highlighted before the discussion of the superiority of AlwaysCovered to the other two.

BioChallengers is a biotech company that deals with developing and commercializing therapies for Multiple Sclerosis. This was to address the issue of side effects due to the current offering in the market. The treatment provided by the product of BioChallengers potentially worked better and lasted longer. However, there were a lot weakness of this proposal. Investing in this technology means that there would be no profit in any short run. There was limited transparency about the product. It was also noted that in this company, big pharmaceuticals do not invest which built doubt. There was no place on the board and have to rely in the external information. Vine Brook would have no control over the company. The investment size was also high ad compared to the size of the funds.

SweetDreams is the most intriguing among all the three. Vine Brook had the opportunity to invest in SweetDreams because of its relationship with Plymouth. Plymouth and Vine Brook often brought each other into deals. There was a 25 per cent hike in the share price at the end of the first trading day of the medical device maker where it had recently gone public. Here, Plymouth was involved as a co lead investor by Vine Brook. The investment proposal in SweetDreams is found to be intriguing because the firm was in the process of development of an implantable device which would help to reduce obstructive sleep apnea. This was a potentially serious condition that causes suffering over 40 million Americans. Thus, the company had a promising product. To ensure airways free during sleep, this small implantable device zapped a nerve in the tongue. This device has been already tested in dogs and pigs. The experiment on them was successful and as expected. The device worked on them. However, the major drawback which stopped me to choose this proposal was the serious management problem. The management was bad and the CEO was not stable. It was not clear about the amount of investment and as well as exit strategy was not clear. Also, venture capitalist (VC) has already made investments in many medical devices and thus wants to differentiate.

There is no denial that while selecting the best investment proposal best management is considered to be the most important factor than the other factors such as, product characteristics, quick return on investment or capturing a large and growing market.

3. The paper by Jerald et al. (2018), documents various professional practices in the selection of equity valuation approaches. This includes specific model variations and key input preferences. The paper shows significant differences that were seen in practice across geographies and employer firm types. The neutral survey conducted in this paper was aimed to provide current practice in equity valuation. Stratified random sampling was applied to construct the sample among the professional equity analysts. The goal of this paper was to provide representations of equity valuation practices that are unbiased. The secondary objective is to include elimination if experimenter bias and as well as collecting details on conditioning determinants in valuation model selection.

The following are the approaches of valuation to evaluate individual equity securities:

• A market multiples approach ( such as enterprise value to EBITDA or based on price to earnings or other multiples).
• An asset based approach (such a asset replacement costs, based in book values, asset market values or adjusted book value).
• A present discounted value approach/ Income approach ( such as based on free cash flows, forecasts of future dividends or economic value added income ).
• A real options approach ( sucusage to value equity usage of options model).

The findings of the paper show that market multiples for valuation is used by the maximum survey respondents (92.8 per cent). It is followed by present discounted value (78.8 per cent) and asset based approaches (61.4 per cent). Whereas, a rela options approach was very less used.

The most popular approach was the market multiples approach for valuation. Market multiples can be defined as that approach which consists of:

• Price multiples (based on share price)
• Firm or enterprise value multiples ( based on a measure of firm or enterprise value).

It is known that market multiples are the base for relative evaluation of an asset. This is in regard to the comparable assets. There were two multiples that have the highest usage: price to earnings (P/E) and enterprise value (EV) multiples. The least usage multiples were: dividend yield (D/P) and price to sales (P/S) (Davis, 1998).

The method of valuation could differ on the basis of the sector or the industry of the stock that is being valued. According to the paper by Jerald et al. (2018), a large number of factors influence the method of valuation. Given the differences of the companies that are being valued, there is a lot of diversity among the analysts who evaluate the value and the aim behind the valuations. It should be noted that there must be legitimate differences in the practices of valuation. It is found that there is statistical significant difference in the geographical region usage of valuation methods. It was observed that Asia Pacific and EMEA have significant greater usage of present discounted value (PDV). They use present discounted value approach more than in the Americas. It was also noted that Asia Pacific used the asset based approach more than in the Americas.

There were variations in the regional usage of market multiples. Although, the price to earning (P/E) ratio was the top among all the ratios in all the regions. When the difference in the job function was analysed, it was observed that across job function such as portfolio manager, sell side analyst or buy side analyst, the usage of market multiples is quite similar. Also, for the other valuation approaches the relative ranking is same across job function.

The type of firm such as whether brokerage firm, investment bank, hedge fund or investment management firm also has effect on the usage of valuation techniques. EV multiples were used more often by the hedge funds and investment banks than the brokerage firms and investment management firms. Moreover, hedge funds used the real options approach and asset based approach more than other type firms. They use the present discounted value (PDV) approach less. Real options approach was used less by the investment management firms than the other types of firms. Type of clients such as whether institutional client or private client also affect the method of valuation. Dividend discount model is used more by the analysts who have private clients. They use to present discounted value (PDV) approach less often (Pinto et al., 2019)

Regardless of the geographical region, type of job, type of firm or type of client, it is noted that market multiples and the free cash flow approaches are the most common and used classes of equity valuation models.

The Hongxing Auto Sales and Service Co. is located at Jinhua, a place where rapid growth has been observed. This rapid growth provided people with job opportunities and higher disposable incomes. There was a tradition to maintain high rate of savings. This means the consumers in Jinhua had substantial cash balances from which they can purchase durable goods. The city also has advantage of the convenient transportation network. Under the leadership of Li Hongxing, the company acquired reputation for service quality and earned high profits. After the responsibility of business was taken over by Li Nan, the business of Hongxing performed reasonably well.

To calculate the net worth of a business, the first step is to calculate the total assets. Looking at the balance sheet of the company for the year 2005, the total assets sum to 5,337,541 yuan. The total liabilities of the firm is 2,085,659 yuan. The net worth can be calculated by subtracting total liabilities from total assets. This turns out to be 3,251,882 yuan.

However, a company is lot more than its net worth. The expected revenues and sales also matter while selling a business. It can be noted from the income statement of the company, the earnings after interest and taxes are increasing every year and it is 1,216,534 in the year 2015. It is important to find what a typical business in the industry has worth of sales, say, it may be 2 times of sales.

The most common and widely used approach, earning multiples, can be used here. A multiple of the total earnings or the price to earning ratios has to be calculated. If the price to earning ratio is 5 and the projected sales is 8,000,000 yuan, then the net worth will be 40,000,000 yuan.

References for The Validity of Capital Asset Pricing Model

Davis, G. A. (1998). Estimating volatility and dividend yield when valuing real options to invest or abandon. The Quarterly Review of Economics and Finance, 38(3), 725-754.

Graham, J. R., Harvey, C. R., Chaplinsky, S., Dahlquist, M., Fama, G., Gompers, P., & Smith, D. (2001). The theory and practice of corporate “nance: evidence from the” eld ଝ. Journal of Financial Economics, 60

Gompers, P. A., Gornall, W., Kaplan, S. N., & Strebulaev, I. A. (2020). How do venture capitalists make decisions?. Journal of Financial Economics, 135(1), 169-190.

Griffith, R., & Chandy, P. R. (1986). A note on yield-to-maturity approximations. Interfaces, 16(3), 90-97.

Hand, J. R., Holthausen, R. W., & LEFTWICH*, R. W. (1992). The effect of bond rating agency announcements on bond and stock prices. The journal of finance, 47(2), 733-752.

Kisman, Z., & Restiyanita, S. (2015). M. The Validity of Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) in Predicting the Return of Stocks in Indonesia Stock Exchange. American Journal of Economics, Finance and Management, 1(3), 184-189

Pinto, J. E., Robinson, T. R., & Stowe, J. D. (2019). Equity valuation: A survey of professional practice. Review of Financial Economics, 37(2), 219-233

Schill, M. J. Royal Mail Plc: Cost of Capital.

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