Capital Asset Pricing Model and Arbitrage Pricing Theory

Question: Discuss about the Capital Asset Pricing Model and Arbitrage Pricing Theory. Answer: Introduction: Capital budgeting is a financial planning process that firms use to appraise investments. The process analyses amounts the company is investing and the return that the company will get from a project. Capital budgeting uses the following methods to calculate cash inflows of the investment to the company; payback period, internal rate of return, net present value and discounted cash inflow. The process involves assumptions that enable projections of cash inflows and discounting rate that will prevail in the future. Sensitivity analysis is a technique that analyses results of an investment when an independent value changes (Tsanakas and Millossovich, 2015). Sensitivity analysis enables calculation of change of independent variable when a change in dependent variables occurs. Sensitivity analysis generally helps evaluate how sensitive inflows are to change in investment outlay and economical factors like discount rates, tax etc. In corporate finance management, sensitive analysis involv es analyzing how individual input when making capital budgeting decisions influence NPV, IRR or other outflows. Sensitive analysis is an important concept in corporate financial management. The concept helps managers to know what will happen to the financial decision that they make when some assumptions change. This happens when the assumptions made when appraising investments are unreliable. In this case, the manager is able to use sensitivity analysis before making a capital budgeting decision and can know how sensitive certain an input is and the impact of the assumption not holding. Secondly, the manager is able to know how output is dependent on each input. This will allow manager to make an informed decision and get prepare of the expected results when an input changes. Lastly, the sensitivity enables mangers to calculate risk associated with the project. Mangers are able to calculate the likelihood of achieving the expected results or not getting them. Calculation of risk improves the information that the manager has when making a capital budgeting decision. In general, sensitivity anal ysis concept is important for it improves decision making by availing more accurate information and also severs as an investigative tool when appraising an investment. Sensitive analysis have drawbacks too when making capital budgeting decisions. The metrics used in sensitivity analysis is esoteric. Few managers are able to interpret the metrics causing inability to use the information. This leads to information loss in the process discrediting the purpose o the analysis. Secondly, sensitive analysis practices lack pace with the growing complexity of the investment world. The standard practices are not updated to meet the growing complexity in the field of financial management. This makes it impossible to use the concept in investigating projects. Lastly, the sensitivity analysis concept lacks approval for efficiency when appraising and estimating in the discipline and are easily omitted. This undermines the concept reducing it acceptability as an investigative tool in capital budgeting decisions. Scenario Analysis Scenario analysis is a evaluating technique of an investment that analysis several expected return. The concept involves evaluating capital budgeting decisions by creating another scenario to compare returns. The analyses are done on different variables to evaluate inflows of an investment when variables are changed. Inputs are used differently to produce different possible return in an investment. This approach gives a financial manager a wide view of the possible returns from an investment. This informs the manager on the expected returns when inputs go below the actual level and when they exceed. Analysis is done for the capital budgeting decision when the input factors are unfavorable and when they are favorable and their likely returns. Scenario analysis is carried out in two forms; the first one is the best case or worst case and multiple cases. The best/worst case involves analyzing an investment decision at it minimum or it maximum. This enables managers to know the return fo r extreme cases. Multiple cases involves having several different scenario analysis that multiple inputs to show all possible returns from an investments. Scenario analysis has several benefits to capital budgeting decisions. This concept increase preparedness when making a capital budgeting decisions. The concept allows several evaluations of different outcomes enhancing preparedness to different return when certain factors and inputs prevail. This ensures that all potential problems are spotted and considered in advance. Managers making capital budgeting decisions analyze investment differently making it easy for them to prepare for any uncertainty or risk in the proposed investment. In addition, the concept enables managers to think about the future enabling brainstorming of the investment before implementation (Meyer and Kiymaz, 2015). Secondly, scenario analysis concept enhances generation of investment strategy. The concept outlines several combinations of inputs for several inflows. Managers are able to choose the optimal input for optimal returns. Choosing from the best combination of input enables capital budgeting decision to be based on the best strategies that will result to maximum return on an investment. Thirdly, the scenario analysis concept induces efficiency on the decision made on capital budgeting. The concept allows different combination of resources in the investment to maximize wealth creation to the shareholders. These helps managers to make decisions that use the least input and yield high returns. This enhances efficiency in the company enabling achievement of the financial management goals. Lastly, the scenario analysis concept enables embracing of u8ncertainity and risk when making capital budgeting decisions. Decision makers are able to analyze different scenarios of the same investment. This technique enables undestandi9ng of the uncertainty and embracing them in the implementation of the proposed investment. Capital Asset Pricing Model and Capital Market Line Capital asset pricing model is a financial model that is used to determine if additional investment is appropriate (Weston, 2008). The model determines the rate of returns required in order to make an investment decision to invest. CAPM calculates specific firms expected returns on invested equity (Shapiro, 2005). The model is based on the risk free rate, beta coefficient and expected rate of return. CAPM seeks to explain the relationship between risk and the expected returns to the investing company (Berkman, 2012). It involves the process of measuring systematic risks on investments and calculating the rate that the investment will yield. The CAPM formula is; The model makes an assumption that risk return profile of an investment can be optimized. This is attaining at a point where an investment displays the least level of risk of returns. This point indicates that the risk involved in investing in a particular project is lowest with the return that the company will get. The model assumes that the company making investment decisions based on the aim to maximize returns, price takers, rational and risk averse. These assumptions have to hold in order to Capital Asset pricing model to be accurate. The CAPM is an important model and is majorly used to determine fair price of a proposed investment (Sinha, 2012). Capital Market line is a line that is drawn tangent to in capital asset pricing model representing rates of returns from an efficient investment (Capital asset management, 2001). This efficiency is as a result of optimal risk level and risk free rate of return. The graph is draw as expected returns against standard deviation. CML is the intersection of returns from total market and risk free investment. From the graph showing Capital market line, point L represents a section of investment assets that are free from risk. Point M represents the optimal point where highest expected rate of return has the least risk. At point R has high return that is associated with high risk. Investing at point R would mean the company will have to stand high risk associated with investments at this point. This means that the possibility of the company losing it invested input at this point is very high. It also means that if not risk that occurs, the company can have the highest return within the same during of time. A rational company will invest at point M where the risks are minimum and maximum returns. This point is the optimal point of investment. The market prices are also fair at this point. There exist a lot of similarity between capital asset pricing model and capital market line. First, both models consider level of risk when deciding on investment decision. These models assume that investment decisions are done on rational basis. There are efforts to minimize risk and invest in lowest risky assets (Dobrnszky, n.d.). Second, both models can be used to determine the expected returns to an investment. These models are able to analyze and calculate the expected return on investment. Both models calculate returns that are expected from an investment. These returns help analysts make decision on the best decisions when investing to ensure that investments have maximum returns. Lastly, both models calculate market fair prices. The models produce fair prices in the market that equity can be invested at. These prices enable decision on the amount at which investment can be made. Above these prices, the models dictate that there be a bargain or else not make investment (Julian to, 2013). Apart from similarity, there exist few differences between capital asset pricing model and capital market line. Capital asset pricing model involves investing at an optimal point of risk level and expected return s while capital market line involves investing in a point below return risk free. Another difference is that CAPM is more comprehensive and involves more data in order to calculate an optimal point for investing while CML depends on CAPM to draw an interception to find area below risk free level for investing. This indicates that CML is progress models build ins9ide the CAPM. References Bennouna, K., Meredith, G. and Marchant, T. (2010). Improved capital budgeting decision making: evidence from Canada. Management Decision, 48(2), pp.225-247. Berkman, H. (2012). The Capital Asset Pricing Model: A Revolutionary Idea in Finance!. Abacus, 49, pp.32-35. Capital asset management. (2001). 1st ed. Washington, D.C.: National Academy Press. Dobrnszky, P. (n.d.). Scenario Analysis in Charge of Model Selection. SSRN Electronic Journal. Julianto, L. (2013). Comparative Study between Capital Asset Pricing Model and Arbitrage Pricing Theory in Indonesian Capital Market during Period 2008-2012. Asia Pacific Management and Business Application, 2(2), pp.111-119. 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