Corporate finance Assignment Example | Topics and Well Written Essays - 1500 words

Corporate finance - Assignment ExampleBlume (1993) had suggested that CAPM provides a model of equilibrium pretend/return kindred. The CAPM also denotes that there exists a linear relationship between expected return and non-diversifiable systematic endangerment which is denoted as beta. This linear relationship is denoted as security market line (SML). In SML, the systematic stake of a portion out is compared with the risk and return of the market as well as the risk free rate of return for estimating the expected return of a particular character (Arnold, 2008 Pike and Neale, 1999). Figure 1 Source (Ogilvie, 2008) CAPM defines risk as an result to which the return of the portfolio of shares or a single share has a covariance with the return in the market. If it is assumed that CAPM correctly defines the capital market, then the risk/return relationship can be established for an efficient market strategy. The CAPM equation represents this relationship and expected return is se en to be a function of the following equation R = Rf + ? (Rm Rf) Where R = expect return on the portfolio or share. Rf = Risk-free rate of return. ? = Beta. It signifies the volatility of the portfolio or the share relative to the market portfolio. Rm = Expected return on the market portfolio. Rm Rf = Market risk premium (Harrington, 2001 Jones, 1998). Parameters of CAPM The risk-free rate of return It signifies the return on the asset that has no risk. This indicates that it uncomplete has covariance nor variance with the return on the market. In reality, it is difficult to find an asset of this kind and doubts prevail regarding the actual existence. Various proxies like, treasury bills and government bonds, are employ in this stead. However, these proxies are also subjected to inflation and uncertainty and cannot be considered as entirely risk-free (Harrington 2001 Watson and Head, 1998). Return on the market For CAPM, one of the most burning(prenominal) implications is the e xistence of optimally efficient market portfolio. In theoretical approach, the market portfolio consists of risky assets that are diversified among the portfolios available. Once this portfolio is held, it is not possible to diversify the risk any further. The market return is the return on the market portfolio, including all the risky assets. Unlike risk-free rate, the market return is difficult to estimate. It is approximated by apply the indices of the stock exchange as the proxy for the market. However, issues exist regarding the selection of index to be used as proxy. Beta It is the prise of non-diversifiable risk and relative measure of risk. It is the risk estimation relative to the market portfolios. In simple words, it measures the price volatility of the share or a portfolio of shares and also, how the expected return of the portfolio or the share will react in consideration to the movement of return in the market portfolio (Moyer, McGuigan and Kretlow 2001 Jones 1998). Hence, beta is the measure for the difference between the return of the various portfolios of share or shares (Ward, 2000 Jones, 1998). Application of Capital Asset Pricing Model in Corporate Decision making CAPM argues that total risk is measured by