Page 105 - DMGT207_MANAGEMENT_OF_FINANCES

Management of Finances

Notes received a dividend of 14 in 1998 and 1999 and 14.5 from 2000 to 2002. Calculate the cost of
equity capital based on realised yield approach with 10 per cent discounting factor.
Solution:

Years Cash inflows ( ) DF 10% PV of Cash inflows ( )

1998 14.0 0.909 12.7
1999 14.0 0.826 11.6
2000 14.5 0.751 10.9
2001 14.5 0.683 9.9
2002 14.5 0.621 9.0
2003 300.0 0.621 186.3
240.4

ha

) Purc
(
se price in 1998 240.0
-

0.4
At 10 per cent discount rate, the total PV of cash inflows equals to the PV of cash outflows. Hence,
cost of equity capital is 10 per cent.
Capital Asset Pricing Model (CAPM)
CAPM provides a framework for measuring the systematic risk of an individual security and
relates it to the systematic risk of a well diversified portfolio. In the context of CAPM, the risk of
an individual security is defined as the volatility of the security's return vis-à-vis the return of a
market portfolio. The risk (volatility) of individual securities is measured by  (beta). Beta is a
measure of a security's risk relative to the market portfolio. Since diversifiable risk does not
matter, beta is thus a measure of systematic risk of a security.

Risk free security has no volatility and it has a zero beta:
The Capital Asset Pricing Model is given in equation:
K = R + b × (km – Rf)
1 f 1
Where K = required rate of an asset I
1
R = risk-free rate of return, commonly measured by return on treasury
f
bills or government securities
b = beta coefficient or index of non diversifiable risk for the asset I
1
K = market rate of return on the market portfolio of assets
m
The CAPM can be divided into two parts (1) risk-free interest Rf which is required return on a
risk free asset typically treasury bill or short-term government security and (2) the risk premium.
These are respectively the two elements on the either side of the plus sign in the above equation.
The (k – R ) portion of the risk premium is called the market risk premium, because it represents
m f
the premium - the investor must receive for taking the average amount of risk associated with
holding the market portfolio of assets.
The risk premium is the highest for small company stocks, followed by large company stocks,
long-term corporate bonds, and long-term government bonds. Small company stocks are riskier
than large company stocks, which are riskier than long-term corporate bonds (equity is riskier
than debt instrument).
Long-term corporate bonds are riskier than long-term government bonds (because the
government is less likely to ravage on debt). And of course, treasury bills and short-term
government securities because of no default risk, very short maturity virtually risk-free as
indicated by zero risk premium.

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