Corporate Finance Assignment Sample

Corporate Finance: A Comprehensive Analysis of Efficient Market Hypothesis and Capital Asset Pricing Model

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Corporate finance is a division which cross-check the financial activities of a firm. It has its eyes on optimising the value of shareholder's earnings via long term and short term planning and using diverse strategies (Higgins, 2012). The area of corporate finance covers variables such as capital investment to investment banking. This analysis tells about the way in which firm pays for investment and its effects on shareholders' investment investments (Baker, Singleton and Viet, 2011).

Theory

Review of fundamental features of Efficient Market Hypothesis (EMH) and CAPM

Efficient Market Hypothesis: An optimum market is elaborated as a market, where huge numbers of rational, profit optimisers actively competing with each effort to forecast future values of individual securities, and where crucial information is available freely to all participants (Damodaran, 2016). Efficient market hypothesis is related to the theory which covered in financial economics that demonstrates the asset prices entirely and demonstrates all the applicable information.

A key application is that which is not possible to “beat the market” regularly on a risk adjusted basis as market prices need to only respond to the new or advanced information or changes in discount rates (Brigham and Daves, 2012). EHM emphasised that the stocks are always traded on fair price which was completely wrong and this has been changed by buying undervalued inventory and selling the same inventory for the inflated prices. There are three variables of hypothesis i.e. weak, semi-strong and strong.

In weak form efficiency: future stock prices are not able to forecasts by way of assessing prices from the past data. Higher returns cannot be attained in the long run by implementing investment strategies which are based on the historical share prices or other historical data. Technical analysis tools do not usually make higher returns via few forms of fundamental analysis which might render excessive returns (Chandra, 2011). This demonstrates that future share price movements are identified wholly by information not covered in the price series. Therefore, prices are required to adhere random walk (Dewally and Shao, 2014).

Under semi-strong form of efficiency: This is applied that share price adjust in accordance with publicly available new information, and in an unbiased fashion. So that no extra return can be increased by trading on that information (Ling and Archer, 2012).

Strong form of efficiency: This is rightly observed that share price demonstrates entire information and no one can gain higher returns. Strong form of efficiency cannot be possible, except in the case where the laws are universally neglected (Ehrhardt and Brigham, 2016).

Capital asset pricing method: This is the tool which is used by the business analysts to identify a theoretically adequately required rate of return of an asset, so that the firm can incorporate decisions about adding assets to a strong diversified portfolio (Altman and Hotchkiss, 2010).

The Security Market Line importantly graphs the results from capital asset pricing model. X axis demonstrates the risk and y axis reflects the forecasted return (Brealey and et. al., 2012). Market risk premium is identified from the slope of SML (Fan, Wei and Xu, 2011). The connection between risk and return is plotted on the securities market line which demonstrates forecasted return as a function of Beta. The formula of SML is:

Required return = Risk free rate + (beta coefficient × equity risk premium)

Under this, the risk is recognised by way of beta and return is known as the required rate of return. It is also known as required rate of return (Flannery and Hankins, 2013).

Literature Review

Critical review related to CAPM with discussing effectiveness of the model in 21^st century

The term beta in the CAPM is symbolizes the systematic risk of return that is used as exposure of market (Saunders and Cornett, 2012). The portfolio frontier depicts every best combination of assets in a portfolio. With the diversification in frontier line with an infinite or positive value indicate every possible outcome for the company.

Effectiveness of CAPM model on 21^th century:

As per Liang, (2011), CAPM is a model which helps in identification of the relationship between risk and expected returns for assets. So, this model contributes in the determination of risks which are associated with transactions and assets as well as their ability of generating profits (Fracassi, 2016).

According to Arnold, 2013 This CAPM model is used by the investment bankers and financial analysts in measurement of risks which are associated with the investments made by them in different securities.

In the words of Chandra, 2011 early work of mean variances portfolio theory is provided the foundation on which capital asset pricing model will be develop. There are mainly three key assumptions are made which are associated with expected risk premium of an assets return. It can be attaining by an effective analysis on complete market instead of common level (Grinblatt, and Titman, 2016). The beta term in CAPM means that systematic risk of an assets return is often said to be effective parts of market.

As per Higgins, 2012 the portfolios frontier depicts all every combination of assets in a portfolio. With proper diversification can shift frontier to left and a reduction in risk for a specific return.

In the opinion of Myers, 2012 if it has been assumed that investors are having homogeneous mean-variances thought then all external parties can hold the contact portfolios (Brigham and Houston, 2012). Every point on the line provide an economical finance that investing in only risky assets. Some assumptions are:

• Position of market is in equilibrium stage
• Mean-variance investors
• Consistent beliefs regarding the mean-variance (Pettit, 2011).

There are large number of effectiveness of CAPM model in 21^th century which defines below:

• This model is effective for investment bankers, financial analysts and accountants in calculation of cost of equity and the risks which are associated with assets (Haas, 2014). This also helps in calculation of NPV of future cash flows and the value of company.
• This model is important for continuous learning and improve their finance career by helpful in learning of these like, WACC, valuation methods, comparable company analysis and finance modelling guide (Moles, Parrino and Kidwell, 2011).

Application

Implication of models and findings:

Finding of EMH:

• It implies that future prices change is determine wholly by data not contained in the prices series.
• Investors are risk aversion they need to plan their investment in more effective manner.
• It is correct to have present stock price which is already reflect past and present published information those are available with them (Calomiris and Herring, 2013).

CAPM:

• It is mainly providing information about risk and expected return a company is getting during the year.
• The equity market premium include foreseen return from the market as a entire low the risk free rate of return (Almeida, Campello and Weisbach, 2011).
• It is used to determine whether investors security is undervalued and overvalued.

Comparison CAPM with the market

Portfolio A low:

Portfolio A

Low Beta

Portfolio A have an average beta of 0.53 which represents less volatile to its benchmark. However, this also said that the company. However, average return of this portfolio is 0.50%. which is less than the FTSE average return 0.70.

From the above graph, this has been observed that the portfolio A is having 10 companies from FTSE250. These are having less beta and standard deviation. Which represents that these companies are having more return with less risk. This is presumed to be the best portfolio and investors will tend to invest their money for buying this tool. The average return of this beta 0.50% and average beta of this portfolio is 0.53. TEP company’s beta is -0.2 which reflects the least beta. Along-with this, standard deviation of this company is also least as compare to others which is covered in this portfolio.

Justification:

This portfolio A is having lower return than the market. Hence, it is assuming to be the underperforming portfolio. Thus, investors should not invest under Portfolio A due to the low return then the market.

Portfolio B Middle:

Portfolio B

Medium Beta

The market average return of portfolio B is 0.81% which is more than the market. Hence, this reflects that this portfolio is earning more effort than the FTSE 250.

According the above graph, this has been observed that the 10 companies are selected from the FTSE250 which are having the middle beta and standard deviation. TRY company is having 1.05 beta which represents that the company is having more risk than others. while, CAPC have higher standard deviation in this portfolio. This portfolio has average return of 0.52 and while this is having average Beta of 0.88. which reflects more return than the portfolio A.

Justification:

The portfolio B is having high rate with 81% of market share so it is more effective for the investors to invest under this portfolio. They would get more positive outcomes from there capital investment.

Portfolio C High:

Portfolio C

High

Portfolio C is earning 0.54% return which represents less than the average market return which is 0.70. Which shows that the portfolio is under performing and this means that the performance of this portfolio does not reflect the good return.

From the above information beta value is higher from above initial level and with the risk in increasing the standard deviation is also maximising (Bolton, Chen and Wang, 2011). While on the other hand, this has been observed that 10 companies under this portfolio are having higher beta and standard deviation which reflects the greater risk with the higher return. However, OCDO have greater beta 2.49 which reflects higher risk along-with the greater return.

Justification:

The Portfolio C is having less average return and its beta risk is also above 1. Hence, the investors are at highly risk if they are investing under this portfolio. As the market is more volatile as compare to the return they are getting from the investment.

Overall comparison:

From the above three portfolios A, B and C. They are indicating low, medium and high beta growth return. Out of them, portfolio B is more effective for the purpose of making investment. It is so because they are generating more return from the market.

Trey nor Ratio: This is calculated by using below mentioned formula:

Average portfolio Return-Average risk free rate/ Beta of the portfolio.

Sharpe ratio: This is calculated by using under mentioned formula. Which is described as under:

Expected portfolio return- risk free rate of return/portfolio standard deviation

Impact of Sharpe and Tyrenor

In Sharpe ratio of a risk free assets is completely zero. Portfolios diversification having negative correlation (Cao, Pan and Tian, 2011). In order to reduce the risk increase in Sharpe ratio is more beneficial.

While, Traynor is rewarded as to volatility ratio. It consists of optimal risky portfolios which is having passive market. It measures the risk premium compared to the portfolios beta.

Portfolio D:

Portfolio D is having 0.41 return which also reflects the less return than the market. Which reflects the underperforming performance of the portfolio D.

In the above graphs, it has been seen that beta is more fluctuating as compare to standard deviation. At every level the risk is minimising and it will increase profitability for the company. The beta of TRY is higher as compare to other companies but standard deviation is at zero. The average return of this portfolio D is having 0.41 average return which reflects average standard deviation 4.05 (Mathuva, 2015).

Justification:

As the market return in lower than average standard deviation which is not perfect for the investors to invest their capital. The chances of getting healthy return in very low because the market is more volatile.

 Under this portfolio, this has been said that the average return of the cited portfolio is presumed to be the 0.70 which is equally to the market return.

According to the above graph, it has been clearly seen that there is a huge deviation in the beta risk with that made impact on the standard deviation of the company. The average return of this portfolio is having average return of 0.70% and average standard deviation is about 6.95%.

Justification:

By observing the market return and average return is neutral so the investors have the choice to either make investment or not. The growth and return earning chances can be equal at each level of investment.

Portfolio F reflects an average return of portfolio return of 0.52% which is less than the market average return of 0.70%. this means firm is underperforming.

This particular graph represents necessary information about the average return and standard deviation impacts on various companies (Fan, Wei and Xu, 2011). According to the above information, 9.65% of risk is incur by CAPC company and from which they are getting return of 0.85. It shows the high portfolios of F which is having average return of 0.67 and standard deviation of 9.65%.

Justification:

According to portfolio F, the average return is low as compare to market return with the high standard deviation. It is not positive sign for the investors. As the chance of getting effective return is low.

Overall performance:

After making complete analysis of average standard deviation portfolio D, E and F. Only, portfolio E is more effective than other two. As market return is equal and investors can generate healthier outcomes from their investment.

Comparison:

Conclusion

It has been concluded from above report that EMH theory and CAPM model help investment advisor in determination of risk and return which is associated with securities. CAPM model is much more effective than EMH theory as it helps them in determining actual investment and calculation of NPV of future cash flows. This helps in calculation of risk associated with the securities and identification of the return which are received from such securities. This is the reason CAPM model is mainly used in 21^st century. This will have great importance to the financial analysts to develop their financial career by learning new things. It is recommended that CAPM model is more effective in comparison to EMH theory and have great impacts in today's world. This shows the relation between return and risk.

Books and Journals

• Almeida, H., Campello, M. and Weisbach, M.S., 2011. Corporate financial and investment policies when future financing is not frictionless. Journal of Corporate Finance. 17(3). pp.675-693.
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• Baker, H.K., Singleton, J.C. and Veit, E.T., 2011. Survey research in corporate finance: bridging the gap between theory and practice. Oxford University Press.
• Bierman Jr, H., 2012. Increasing shareholder value: distribution policy, a corporate finance challenge. Springer Science & Business Media.
• Bolton, P., Chen, H. and Wang, N., 2011. A unified theory of Tobin's q, corporate investment, financing, and risk management. The journal of Finance. 66(5). pp.1545-1578.
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• Calomiris, C.W. and Herring, R.J., 2013. How to Design a Contingent Convertible Debt Requirement That Helps Solve Our Too‐Big‐to‐Fail Problem. Journal of Applied Corporate Finance. 25(2). pp.39-62.
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• Burton G. Malkiel. The Efficient Market Hypothesis and Its Critics. 2017. [Online]. Available through:<https://www.cfapubs.org/doi/full/10.2469/dig.v33.n4.1367>.
• Devid W Mullins, Jr. Does the Capital Asset Pricing Model work? 2017. [Online]. Available through:< https://hbr.org/1982/01/does-the-capital-asset-pricing-model-work>.
• Jeng, Christopher. The Effect of Market Volatility on the Capital Asset Pricing Model (CAPM) Beta. 2013. [Online]. Available through:<hhttp://dataspace.princeton.edu/jspui/handle/88435/dsp012n49t1771>.
• Kim Petch. Investing strategies & styles- Are you an Alpha or Beta Investor? 2018 [Online]. Available through:< https://www.moneycrashers.com/investing-strategies-styles-beta-alpha-investment/>.

APPENDIX

Appendix: 1