Custom essays, dissertations, coursework & essay help from the UK's original custom essay writing services provider
Free Essays - Finance Essays
Accounting and Corporate Finance.
The Capital Asset Pricing Model:
CAPM is used for the valuation of securities and investments using a Discounted Cash Flow (DCF). Its aim is to define the relationship between return and risk on investments and securities by measuring the risk-adjusted interest rate. The ideology behind this model, assumes that a vigilant investor will invest in a security with an expectation of a market rate of return with minimal risk. However, investors must also realise that market rate of return reflects a market rate of risk.
Ideally, investment risk is assessed by using beta; Beta is the overall risk in investing in a large market¯. Beta measures the correspondence between the value of the security and the market. Beta is used in calculation of interest rates for CAMP. Financially, every company has its own beta (risk) according to their risk assessment; whereas, the overall market has its beta of 1.0. If the beta of a security is, more than 1.0 it poses higher risk but better return on investment and a beta lower than 1.0 poses lower risk with lower return.
Realistically, there are number of risks associated with companies other than overall market. A cautious investor will not examine a company's beta in isolation before concluding on an investment decision. Regardless of a good beta and minimal threat from the market, a company is also exposed to other risks as a possibility of the popularity of the chain, locality and so forth.
The Capital Asset Valuation Model Formula:
DCF= r = rf + ( ? Ć— (rm - rf))
rf = represents the risk free rate of the shares
rm = represents the average forecast rate of return of the market
? = represents beta, risk of shares in the diversified portfolio of the market.
(rm - rf) = equity risk premium
Next Plc CAPM can be valued as where the risk free rate of shares is 4.3%; rate of return is 17.5% and the beta stands at 0.97:
Next's CAPM= 4.3%+0.97(17.5-4.3)= 17.1%
M&S CAPM can be valued as where the risk free rate of shares is 5.8%; rate of return is 19.5% and the beta stands at 1.06.
M&S CAPM= 5.8%+1.06(19.5-5.8)= 20.32%
According to these figures, the required rate of return and the costs of equity for Next is 17.1% and for M&S is 20.32%. Thus, M&S bears more risk and requires greater return and greater cost for company to finance equity.
Practically, there are uncertainties with the estimation of equity risk premiums as it comprises of working backwards from market profit growth forecasts and current share prices to the equity risk premium¯. Practically, this is inadequate for valuation of risk in shares.
Advertently, risks that are unconnected to the market can be controlled by diversification of the shares' portfolio; whereas, risks correlated with the market are uncontrollable. Factually, there are two types of risk associated with companies: systematic and unsystematic risks. Systematic risks in company's cash flows, which are unconnected and unspecific to the company. Conversely, unsystematic risks in company's cash flow are associated with factors specific to the company.
In evaluation of the accounts of Next plc and Marks Spencer, the application of CAPM would render the following results:
According to the Next Balance Sheet fore 2004 and 2005 there appears to be a dramatic increase in the shareholders funds. In 2004, funds stood at 155.1 And in 2005, it was 272.7 this is an increase of 75%. Additionally, share capital decreased to 26.1 from 26.5 this was consequent to the buy back of shares.
Goodwill valuation has decreased by £4.3million from £36.2million to £31.9million, which is reflected in the revaluation reserves figure.
The figures in consolidated cash flow statement of Next Plc represent a consistent and stable cash flow as the company debt has depreciated over the year 2004 and 2005. This is reflected by the decrease in finance lease payment, which was £150m in 2004 and only £60m in 2005. Total net debt had reduced to £250.8Million in 2005 in comparison to the 2004 figure at £306.9m. There had been incredible recovery from negative figure of £4.3million as a decrease in cash in 2004, contrasting with the increase in cash in 2004 at a positive figure of £2.0million.
On the other hand, the consolidated cash flow statement of M&S represents a constant and significant decrease in cash inflow, according to the figures 2004 there was an increase of cash inflow at £164.6m, whereas in 2005, there was a decrease of in cash flow with a negative figure of -£120.4m. Inadvertently, this is a -73% of decrease in cash inflow (-120.4/164.6*100= -73%) this is reflected by the extra expenditure in the acquisition of subsidiaries (extra cost of £125.9m) and dramatic reduction in management of finances (2004= £347.0m, 2005=negative -£1,507.5m).
Over the year, Next Plc faced unprecedented reduction of (250.8/306.9-1= 18.3%) in its net debt. In 2004 Next was geared at 227.4% (352.7/155.1*100) but in 2005 its' gearing drastically dropped to 128% (349.3/272.7*100) making an intensive movement in the market by representing lesser risk for its shareholders and potential investors. Comparatively, Marks & Spencer (M&S) had faced an intensive period with the increase in its net dept in 2004 it was £1,994.7m and currently, 2005 it stood at £2,099.0m this is an inflation of (2,099.0/1994.7-1*100=5.2%) this is likely to be related to the incurred acquisition cost of peruna costing £125.9m and tender offer expenses of £14.9m. With reference to gearing, M&S gearing in 2004 was (£2,519.6/£2,454.0*100=102.7%) and currently 2005 stands at (£1,919.7/£521.4*100=368.2%); this dramatic increase in gearing renders M&S in an intensively volatile position in the market, resulting in greater return expectations from shareholders for taking excessive risks.
The Dividend Valuation Model:
Dividends Valuation Model is calculated by using the expected dividend for the coming year; this can be estimated by evaluating the ex-dividend say over 4 years in order to estimate the forthcoming dividend. Subsequently, this figure is multiplied by (1+ expected future growth rate of return) then divided by (shareholders' required rate of return subtract expected future growth rate of return). This is also known as the Gordon Growth Model. Conversely, some models calculate dividends yield by taking the total dividends paid per share over the course of a year and dividing by the share price¯. As an example, if a share trades at 360p with a dividend of 40p over a year this will render a dividend yield of 11.1%.
The Gordon Growth Model Formula:
P0=D0(1+g) = D1
(r - g) (r - g)
Whereas:
P0--represents current ex-dividend market price of the share
r-- represents shareholders' required rate of return
g-- represents expected future growth rate of dividends
D1-- represents declared dividend at time t1
n-- represents number of years the share is held for.
Having evaluated the accounts of Next plc, following are the dividend payments respectively from 2002, 2003, 2004 and 2005: 27.5p, 31p, 35p, 41p
In determining Next plc dividend yield, it is practical to establish future growth rate of dividend. As estimation, an expected dividend for the coming year is likely to be 47p. Ideally, this means 27.5(1+g)4=47 reversing this formula g = 4? 47 - 1
27.5
Using this formula g = 14.3% which is the expected growth rate of dividend.
If Next's shareholders required rate of return is 17.5% then the dividend valuation would render the following result:
47(1+ 0.143) = £16.79
(0.175-0.143)
The £16.79 represent the current ex-dividend market price of the share. This is roughly estimated but it resembles the current share price of £13.99.
Regarding M&S, which had a dividend pay out in 2004 11.5p and 2005 12.1p. Possibility of 13.7 dividend; estimated future growth rate of dividend is 9.1%. If the required rate of return is 19.5%, following result will appear:
13.7(1+0.091)= 143.7p
(0.195-0.091)
The Earnings Yield Method:
Earnings yield is calculated by inversing the PE ratio formula which is (SharePrice/EPS=PE). Whereas, Earning Yield=EPS/SharePrice. Perceptibly, both PE and earning yield will assist an investor in deciding to invest or not.
Inadvertently, a higher PE signifies a reluctance from prospective shareholders as the share of a company's profits will cost more than others with lower PE. Nonetheless, the underlining doctrine for a higher PE is the reflected earning growth is faster than expected and possibly at a lower risk earning.
Commonly, PE is more regularly used by vast range of investors than earning yield. On the contrary, earning yield is relatively more consistent with methods such as dividend yield, bond yields and interest rates.
For Next Plc Earnings Per Share (EPS) has dramatically increased over the years in 2002 was 58.2p, 2003 was 68.7p, 2004 it stood at 93.9p and in 2005 118.5p, over the year, this yields an increase of (118.5/93.9*100-100=26.2%).
Advertently, Marks & Spencer plc EPS in 2004 was 24.2p and in 2005 is 29.1p, this is an increase of (29.1/24.2*100-100=20.2%).
In reflecting and comparing the two retailer shops, it is evident that Next has a much greater (exactly 6%) EPS; and the evidence suggest that a prudent investor is likely to invest in Next than M&S.
SHARE PRICES OF NEXT DURING 2005:
Next's share prices have fluctuated over the year 2005. Especially in January 2005, the share prices was 1681p as the highest over the 12 months period. The lowest was in September at 1268p. Using this figures and adopting the share price of November 23rd 2005 at 1399p and the EPS of 118.5p. This will render PE of (1399/118.5=11.8) and earning yield of (118.5/1399*100=8.47%).
SHARE PRICES OF M&S DURING 2005:
In valuing the earnings yield for M&S, the figures in diagram 4 have been used as an accurate rate of shares on November 23 2005. Share price of M&S stood at 450.8p and the EPS for 2005 was 29.1p this will render a PE of (450.8/29.1=15.5) and a earning yield of (29.1/450.8*100=6.45%). Comparatively, this is a moderate figure as the price of the shares on decreased by 0.33%. Whereas, diagram 2 indicate a higher drop in share prices of Next plc at 1.2%. In application of the other share prices, shares in Next are relatively high in price but there is a higher rate of return as evident in dividend pay outs. Nevertheless, Next PE 11.8 is lower than M&S PE 15.5, whereas, Next earnings yield 8.47% is higher than M&S 6.45% this reflects the fact that Next deliver higher rate of return on shares.
THE ULTIMATE ANALYSIS
Difficulties underlining the usage of Earnings Yield Method is the fact that it only focuses on the return on shares and isolates other factors that are possibly responsible for the operation and cash flow of the company. The PE figure demonstrated by M&S indicate a lower risk for an investor but former figures from the accounts demonstrated that M&S is highly geared, exposing investors at higher risk specially in respect of their preferential position in the creditors' hierarchy¯10 in the event of bankruptcy.
The usage of distinctive methods of valuation reflects a different internal and external analysis and risk factors of the company. For example, when assessing the risk and rate of return, the application of CAMP poses certain implication such as the ignorance and inconsideration of unsystematic risks as they are deemed as capable of eradication by holding diversified portfolios of shares¯.
Comparatively, dividend valuation model possesses difficulties as well, these being that dividend do not grow smoothly and the expected future growth rate of return is only an estimation on an stable trend basis.
As conclusive evidence, CAMP bears a great significance on evaluating risk factors. Thus, it is a best form of valuation of risk and rate of return on a security. If the systematic risk is higher the rate of return is expected to be higher as a parallel liner relationship between systematic risk and return¯.
BIBLIOGRAPHY
WEBSITES
http://www.valuebasedmanagement.net/methods_capm.html
http://www.fool.com/news/commentary/2005/commentary05111103.htm
http://www.riskglossary.com/link/beta.htm
http://www.investopedia.com/articles/stocks/04/113004.asp
http://moneyterms.co.uk/capm/
http://moneyterms.co.uk/dividend_irrelevance/
http://moneyterms.co.uk/earnings_yield/
http://www.citywire.co.uk/Shares/ShareFactsheet.aspx?InstrumentID=2351
http://www.citywire.co.uk/Shares/ShareFactsheet.aspx?InstrumentID=2110
TEXT BOOKS
Arnold, G. (2002) Corporate Financial Management, 2dn edition, FT-Prentice Hall (and the latest edition)
Brearley, R. and Myers, S, (2002) Principles of Corporate Finance, 7th edition, McGraw-Hill.
Copeland, T., Koller, T. and Murrin, J. (2000) Valuation: Measuring and managing the Value of Companies, 3rd edition, McKinsey & Company: John Wiley & Sons
Lumby, S. and Jones, C. (1999) Investment Appraisal and Financial Decisions, 6th edition, Chapman & Hall.
Stern, J. and Donald H. eds. (2003) The Revolution in Corporate Finance, 4rd edition, Blackwell Publishers
Van Horne, J. C. (2002), Financial Management & Policy, 12th edition, Prentice Hall.
Watson, D. and Head, A. (2001) Corporate Finance: Principles and Practice, 2nd edition, Prentice Hall
Finance Essays - Find your free finance essays...
We have a large assortment of free essays available to use as research material. Visit our finance essays from our free essays section.
All of the essays in the "Free Essays" section were written by students and then submitted to us to display and help others. Thanks to all the students who have submitted their essays to us. You should not hand in our essays as your own. We do not condone plagiarism!
UK Essays Sitemaps
UKEssays.com RSS Feed
