Capital Asset Pricing Model (2) Flashcards
What is the aim of a company with well-diversified shareholders?
To determine the required return from its investment projects and then compare this to the forecast return
If project has the same risk as existing activities of the company?
Then the existing WACC can be used
If the project is of a different risk type to the existing activities?
Existing WACC will not be appropriate
What is asset beta?
The unsystematic business risk can be diversified away by investors. Only if business risk does not change
What is equity beta?
Measures the sensitivity to market risks of the equity shareholders’ returns
What happens in a geared company?
The equity beta exceeds the asset beta
In a gearing increases for the equity beta?
Financial risk is added to business risk
What can be used as an alternative to dividend valuation model for estimating cost of equity of a company?
CAPM
What happens when the business risk of a project differs from the existing business risk of the ivnesting company?
it is not appropriate to use the investing company’s existing cost of capital as the discount rate for the investment project.
CAPM can be used instead
First step of CAPM?
Calculate a project-specific discount rate is to obtain information on companies with business operations similar to those of the proposed project
What does an equity beta reflect?
Not only the business risk of a company’s operations, but also the company’s financial risk
How is a simple arithmetic average calculated?
By summing the asset betas and dividing the total by the number of asset betas
What is done before a project-specific discount rate can be calculated?
The financial risk of the investing company must be considered
When can project-specific cost of equity be used as the discount rate?
If the project is financed by equity (either retained earnings or new share issues)
If a project is financed by a mixture of equity and debt?
It would be necessary to calculate a project-specific WACC
