BUSI 2146 Corporate Finance
i. The capital asset pricing theory (CAPM) describes the
relationship between systematic risk and the expected return on
an investment. This relationship is also represented in the CAPM
formula:
E(Ri) = Rf + β x [ E(Rm) – Rf ]
Where
E(Ri) is the expected return on the risk-free asset
Rf is the risk-free rate of return
β is the beta value of the risk-free asset
E(Rm) - Rf is the expected market risk premium
i. Beta is the only risk factor that affects the level of expected return
ii. There is a linear relationship between the expected rate of return
of an individual asset and its contribution to the portfolio’s risk
i. Investors hold diversified portfolios, thus diversifying
unsystematic risk. Therefore, investors only require a return for
the systematic risk of their portfolios.
ii. A standardised holding period is assumed to make the returns on
different securities comparable.
,iii. Investors can borrow and lend at the risk-free rate of return,
where the security market line (SML) intersects with the y-axis.
The SML is a graphical representation of the CAPM formula.
iv. Perfect capital market:
1. All securities are valued correctly and their returns will plot
on to the SML
2. No taxes or transaction costs
3. Perfect information is freely available to all investors
4. All investors have homogeneous expectations
5. All investors are risk averse, rational and desire to maximise
their own utility
6. There are large numbers of buyers and sellers in the market
i. It only considers systematic risk, as the assumption on investors
holding diversified portfolios is reasonable in the real world as it
is quite easy and inexpensive for investors to diversify
unsystematic risks.
i. The idealised world is different with the real world
1. Stock market securities may be priced incorrectly, thus their
returns are not plotted onto SML
2. Investors cannot borrow at the risk-free rate, as the risk
associated with individual investors are much higher than risk
associated with the government
3. Investors also care about the impacts of labour income and
future investment opportunities on their portfolio returns
, 4. Homogeneous expectations
ii. Uncertainty arises in the value of the expected return as the risk-
free rate which yields on short term government securities
changes daily, also creating volatility
iii. Return on the market are backward-looking and may not be
representative of future market returns
iv. Beta is estimated by past returns thus may not be reliable to
describe expected returns and future beta
v. Beta fails to explain the cross section of average stock returns
and combination of size and book-to-market equity (Fama and
French,1992)
vi. A strictly diversified market portfolio is impossible to be observed
and obtained. Thus, the benchmark market index serves as a poor
proxy for the market portfolio and would have predictive errors
(Roll, 1977)
Although CAPM faces numerous criticisms, it still remains as a useful
tool to compare between investment alternatives until something better
replaces it.
i. The Modigliani and Miller Theory advocates the capital structure
irrelevancy theory. It argues that no matter how highly or lowly
leveraged a firm is, it does not affect its market value. Rather, the
i. The capital asset pricing theory (CAPM) describes the
relationship between systematic risk and the expected return on
an investment. This relationship is also represented in the CAPM
formula:
E(Ri) = Rf + β x [ E(Rm) – Rf ]
Where
E(Ri) is the expected return on the risk-free asset
Rf is the risk-free rate of return
β is the beta value of the risk-free asset
E(Rm) - Rf is the expected market risk premium
i. Beta is the only risk factor that affects the level of expected return
ii. There is a linear relationship between the expected rate of return
of an individual asset and its contribution to the portfolio’s risk
i. Investors hold diversified portfolios, thus diversifying
unsystematic risk. Therefore, investors only require a return for
the systematic risk of their portfolios.
ii. A standardised holding period is assumed to make the returns on
different securities comparable.
,iii. Investors can borrow and lend at the risk-free rate of return,
where the security market line (SML) intersects with the y-axis.
The SML is a graphical representation of the CAPM formula.
iv. Perfect capital market:
1. All securities are valued correctly and their returns will plot
on to the SML
2. No taxes or transaction costs
3. Perfect information is freely available to all investors
4. All investors have homogeneous expectations
5. All investors are risk averse, rational and desire to maximise
their own utility
6. There are large numbers of buyers and sellers in the market
i. It only considers systematic risk, as the assumption on investors
holding diversified portfolios is reasonable in the real world as it
is quite easy and inexpensive for investors to diversify
unsystematic risks.
i. The idealised world is different with the real world
1. Stock market securities may be priced incorrectly, thus their
returns are not plotted onto SML
2. Investors cannot borrow at the risk-free rate, as the risk
associated with individual investors are much higher than risk
associated with the government
3. Investors also care about the impacts of labour income and
future investment opportunities on their portfolio returns
, 4. Homogeneous expectations
ii. Uncertainty arises in the value of the expected return as the risk-
free rate which yields on short term government securities
changes daily, also creating volatility
iii. Return on the market are backward-looking and may not be
representative of future market returns
iv. Beta is estimated by past returns thus may not be reliable to
describe expected returns and future beta
v. Beta fails to explain the cross section of average stock returns
and combination of size and book-to-market equity (Fama and
French,1992)
vi. A strictly diversified market portfolio is impossible to be observed
and obtained. Thus, the benchmark market index serves as a poor
proxy for the market portfolio and would have predictive errors
(Roll, 1977)
Although CAPM faces numerous criticisms, it still remains as a useful
tool to compare between investment alternatives until something better
replaces it.
i. The Modigliani and Miller Theory advocates the capital structure
irrelevancy theory. It argues that no matter how highly or lowly
leveraged a firm is, it does not affect its market value. Rather, the
