Page 107 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes Cov
(K i , K ) = Covariance of security with regard to market portfolio
m
Cor = Correlation coefficient of the security with the market
jm
Illustration 15: An investor is seeking the price to pay for a security whose standard deviation
is 3.00 per cent. The correlation coefficient for the security with the market is 0.8 and the market
standard deviation is 2.2 per cent. The return for government securities is 7.2 per cent and from
the market portfolio 12.8 per cent. The investors know that, by calculating the required return he
can determine the price to pay for the security. What is the required return on the security?
Solution:

Beta Coefficient =

Required rate of return = 0.072 + 1.0909 × (0.128 – 0.072)
= 0.072 + 0.061 = 0.133

Limitations of CAPM

1. It is based on unrealistic assumptions that are far from reality. For example, it is very
difficult to find a risk-free security, since inflation causes uncertainty about the real rate of
return. The assumption of the equality of lending and borrowing rate is also not correct.
Further, investors may not hold highly diversified portfolio or the market indices may
not be well-diversified.
2. It is difficult to test the validity of CAPM from a practical point of view.
3. Betas do not remain stable over time. Beta is a measure of a security's future risk. But
investors do not have future data to estimate beta. What they have are past data about the
share prices and market portfolio. Thus, they can only estimate beta based on historical
data. Investors can use historical data as the measure of future risk only if it is a stable over
time. This implies that historical betas are poor indicators of the future risk of securities.

Despite the limitations of CAPM, it provides a useful conceptual framework for evaluating and
linking risk and return. An awareness of the trade-off and an attempt to consider risk as well as
return in financial decision-making should help financial managers achieve their goals.

5.4.2 Cost of Preference Shares

The preference share is issued by companies to raise funds from investors. Preference share has
two preferential rights over equity shares, (i) preference in payment of dividend, from
distributable profits, (ii) preference in the payment of capital at the time of liquidation of the
company.

Computation of cost of preference share capital have some conceptual difficulty. Payment of
dividend is not legally binding on the company and even if dividends are paid, they are not a
charge on earnings, they are distributed from distributable profits. This may create an idea that
preference share capital is cost free, which is not true.
The cost of preference share capital is a function of the dividend expected by the investors.
Generally, preference share capital is issued with an intention (a fixed rate) to pay dividends. In
case dividends are not paid, it will affect the firm’s fund raising capacity. For this reason,
dividends on preference share capital should be paid regularly except when the firm does not
make profits.

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