Portfolio management

and the Capit l Asset

Pricing Model

AFTER STUDYING THIS CHAPTER, THE STUDENT SHOULD BE ABLE TO –

understand the background to portfolio theory;

explain the investor’s attitude to risk;
explain the investor’s expected return, required return and how these are influenced by risk;
distinguish between single-asset and portfolio risk and return;
illustrate the use of the probability distribution and expected values in risk management;
assess the risk and return of a two-asset portfolio;
illustrate graphically the combination of two or more portfolios;
explain the effects of diversification on portfolio risk;
explain the derivation and rationale of the securities market line (SML);
explain the derivation of the capital asset pricing model (CAPM);
discuss and illustrate the various applications of the CAPM; and
discuss the limitations of CAPM for capital budgeting decisions.

The modern con ept of portfolio theory was introduced by Henry Markowitz in a paper entitled ‘Portfolio
selection’ published in the Journal of finance in 1952. At the root of portfolio theory is the concept of risk and
return. He p oposed that investors should focus on selecting portfolios (not individual shares) based on the risk
– reward cha acte istics of each portfolio.

5.1 Backgro nd to portfolio theory

The risk f a p rtfolio is measured by the portfolio standard deviation of its expected returns. The expected
returns f a p rtfolio include increases (or decreases) in the value of the portfolio as well as income from the
portfolio in the form of dividends received or interest earned. From a universe of possible portfolios, there is a
e ection of those portfolios that will optimally balance risk and reward and these are referred to as ‘efficient
frontier of portfolios’.
The important criteria for any investment are:
the expected return from the investment;
the variation in that return (risk) – which can be measured by the standard deviation; and
the association between the return for an investment and that for every other investment.

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The theory for portfolio selection is thus dependent on the expected return of a portfolio, in conjunction with
its risk. Investors are assumed to be rational; therefore when comparing investment choices, they will choose
those investments which give greater return when investment risk is equal, and lower risk when investment
return is equal. Efficient portfolios can be identified by examining the expected return (mean) of the individual
shares (or securities) comprising the portfolio, the risk measured by the standard deviation of the portfolio’s
return, and the relationship between all the shares comprising the portfolio (coefficient of correlation).

5.2 The concept of risk and return

The principal objective for a rational investor is to maximise the return on an investment or a portfolio of
investments for a given level of risk. For most securities (shares, bonds, debentures nd the like), the compo-
nents of return are the expected capital appreciation/gains in the investment together with dividends/interest
arising from the investment. In other words for a share, this would be the c pit l growth plus the dividend yield.
It is therefore important that the investor clearly understands the following key issues arising from the
investment process:
What risk and return are.
The origins of the said risk and return.
How risk and return are measured.
Return may be defined in terms of:
l Realised return, that is, the return which has b n arn d; and
Expected return, that is, the return which the inv stor anticipates to earn over a defined investment
horizon in the future.
The expected return is a forecast return and may or may not occur. The realised return is a historic return that
allows an investor to estimate cash inflows in terms of capital gains (or losses), dividends and/or interest
available to the holder of the investment. The return can be measured as the total gain or loss to the holder
over a given period of time and may be defined as a percentage return on the initial amount invested. With
reference to investment in equities, the realised return consists of the capital gain (or loss) plus the dividend at
the time of disposal of the investment.
The risk associated with an investment means that future returns from the investment are unpredictable. The
concept of risk may be defined as the probability that the actual return may not be the same as what is ex-
pected. In other words, risk refers to the chance that the actual outcome (return) from an investment will differ
from an expected outcome. With reference to a firm, risk may be defined as the possibility that the actual
outcome of a financial decision may not be the same as estimated. The risk may be considered as a chance of
variation in returns. Investments having a greater chance of variation are considered riskier than those with a
lesser chance of variation. Between equity and bonds, the former tends to be riskier than the latter as there are
many more variabl s that impact on a share price than on a bond value.
There is a trade-off b tw n risk and return. The higher the risk of an investment, the higher the return that is
expected. Conversely, the lower the risk from an investment, the lower the return. In practice taking on higher
risk may not esult in higher returns. A portfolio consisting of equities (shares listed on the JSE) and derivative
instruments (e.g. options and futures) may yield attractive returns over time but the investor takes on signifi-
cant risk. On the other hand investments in government bonds (e.g. RSA treasury bonds) will yield low returns
for moderate risk. The risk – return trade-off is illustrated in Figure 5.1 below.

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Equities/ Derivatives

Risk – Pro Investor

Risk – Averse Investor

% Return

RSA Government Bonds

Risk (Standard Deviation)

Figure 5.1: Risk – Return Trade-Off

Investors’ attitudes to risk

Investors that require low -risk investments (and as a consequence of such a selection – low returns) are said to
be ‘risk-averse’. Investors with an appetite for higher returns will incur higher risk and are said to be ‘risk-pro’.
In practice investors are constantly on the lookout for either the same risk for a larger return, or the same
return for lower risk. Doing so ensures that enough return is realised for a given level of risk or alternatively, an
appropriate level of risk (deemed to be not excessive) is borne given the expected return of an investment. The
positioning of investors along the risk – return curve is a matter of choice from investor to investor and such a
decision is influenced by a number of factors peculiar to the investor. Risk tolerance depends on the investor’s
goals, income, personal situation, even their egos.

Probabilities and expected values

For a single stand-alone asset
It is assumed that a rational investor invests for capital gains + dividend yield in a given security or portfolio.
Both the dividend income and capital gains are uncertain. Dividend income is dependent on company profita-
bility and whether or not the directors will declare one. Both these outcomes are uncertain. The capital gain is
dependent on the mark t b ing bullish (i.e. the expectation is that share prices will increase, as opposed to a
bear market, where it is anticipated that share prices will decline). Again, quite often, markets are unpredicta-
ble and hence apital gains are not guaranteed. Both the capital gain and the dividend income constitute the
return to the investor. The expected return on a given stand-alone asset security is the average (mean) of the
probability dist ibution of possible future returns, calculated by using the following formula:

n
E (R) = ∑ Pi × Ri
i=1

Where:

E (R) = The expected return on the security

Pi = The probability factor
Ri = The observed return
n = The number of observations

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Example: Expected return on a stand-alone asset

You own a share that has the following probability/return characteristics, based on future scenarios regarding
the state of the economy:

State of economy Probability Rate of return

%
Recession 0,30 –7
Normal 0,60 13
Boom 0,10 23
What is the expected return on the share? (Note: This is referred to as an ex-ante ana ysis, as it is concerned
with future states).

Solution:
Expected return = (0,30 × – 7%) + (0,60 × 13%) + (0,10 × 23%) = 8%

For a portfolio consisting of two assets

The formula for calculating the expected return on a two-asset portfolio is:

E(RP) = WAE(RA) + WBE(RB)

Where:
E(RP) = The expected return on the portfolio
WA = The proportion of the portfolio invested in stock A
E(RA) = The expected return on stock A
WB = The proportion of the portfolio invested in stock B
E(RB) = The expected return on stock B

Example: Expected return on a portfolio consisting of two assets

The probability distribution of the returns of a two asset portfolio is as follows:

Year Probability Return A Return B

1 0,20 5% 50%
2 0,30 10% 30%
3 0,30 15% 10%
4 0,20 20% – 10%

There is a 50:50 split between A and B in the portfolio.

Required:
Calculate the expected return on a two-asset portfolio.

S luti n: Expected return on a two-asset portfolio

WA = 0,50
E(RA) = 0,20(5%) + 0,30(10%) + 0,30(15%) + 0,20(20%) = 12,5%
WB = 0,50
E(RB) = 0,20(50%) + 0,30(30%) + 0,30(10%) + 0,20(–10%) = 20,0%
The formula = E(RP) = WAE(RA) + WBE(RB)
E(RP) = 0,50(12,5%) + 0,50(20,0%) =16,25%

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Single-asset risk measures

Balancing risk and return is important for any investor and hence it is critical to have a proper approach to
portfolio risk management. To better understand the latter, the risk dynamics as applied to stand-alone assets
are first explored. This requires the student to have a grasp of the concept of the normal curve and the statisti-
cal measures of variance, standard deviation, covariance and correlation coefficient.

The normal distribution curve

The normal curve is a symmetrical distribution of scores with an equal number of scores above and below the
midpoint of the horizontal axis of the curve. Since the distribution of scores is symmetrical, the mean (the
average value), median (the middle value), and mode (the most frequent va ue) are a at the same point. In
other words, in a normal curve, the mean = the median = the mode. The following illustrations are based on
population data.

Two Std Deviations below mean μ = 52

σ = 12

Mean
Standard Deviation

16 28 40 52 64 76 88

Figure 5.2: Illustrated example of the normal curve (mathematics results of a matric class)

If we divide the distribution into the standard deviation units, a known proportion of scores lies within each
portion of the curve.

X
μ – 3σ μ – 2σ μ – 1σ μ μ + 1σ μ + 2σ μ + 3σ

68,27%

95,45%

99,73%

Figure 5.3: Percentages of areas under the normal curve

Interpretation: Within a random sample of say 100 pupils 68,27% of them (68 students) will have a math result
of between 40 and 64 (i.e. between one standard deviation to the left and right of the mean) and 95,45% of the
tudents (95 students) will have scores of between 28 and 76 (i.e. between two standard deviations to the left
and right of the mean).

The v riance: The variance and the closely-related standard deviation are measures of how dispersed (spread
out) the distribution of variables (e.g. scores, points, values or results) are around the mean. In other words,
they are measures of variability. The greater the dispersion, the higher the variance. The variance is computed
as the average of the sum of the squared deviation of each observation from the mean.

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The formula for the variance computed from population data is:
2
∑(X – µ)
2 =
σ
N

Where:

σ2 Population variance
X Observed variable (students’ maths score)
µ Population mean
N Number of subjects under analysis
The formula for the variance computed from sample data is:
2
∑(X – M)
2 =
S
N

Where:
S2 Sample variance
X Observed variable (students’ maths score)
M Sample mean
Number of subjects under analysis
N

The standard deviation (σ):

The standard deviation measures the spread of data around the mean value. It is useful in comparing data sets
which may have the same mean but a different range. For example, the mean of the following two data sets is
the same: 15, 15, 15, 14, 16 (by adding them up and dividing by 5, a mean of 15 is obtained) and 2, 7, 14, 22, 30
(by adding them up and dividing by 5, a mean of 15 is derived). However, the second is clearly more spread out
(hence more risky). If a data set has a low standard deviation, the values are not widely dispersed. The standard
deviation is often used by investors to measure the risk of a share or a share portfolio. The basic idea is that the
standard deviation is a measure of volatility; the more a share’s returns vary from the share’s average return,
the more volatile the share is in relation to its price movements.
The formula for the standard deviation computed from population data is:

∑(x – µ )2
i
i
σ =

Where:
= Population standard deviation
xi = Obse ved variable (students’ maths score)
= Population mean
= N mber of subjects under analysis
The form la for the standard deviation computed from sample data is:
2
∑(xi – µ )
i n–1
S =

Where:
= Sample standard deviation
xi = Observed variable (students’ maths score)
= Sample mean
n = Number of subjects under analysis

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Example: Calculating the mean, variance and standard deviation from sample historic data
(Ex-post)
You have observed the following returns on Memeza Limited’s share price:
Year Returns
20X7 6%
20X6 – 10%
20X5 4%
20X4 23%
20X3 12%

Required:
Calculate the average return (mean) on the share over the past five years.
Calculate the variance and standard deviation on the share over the past fi e years.

Solution: Calculating the mean, variance and standard deviati n fr m sample historic data
(Ex-post)
Using the Sharp EL 738 calculator:
Operation 1 Operation 2 Result
MODE 1 0 STAT 0
2ndF M – CLR 0 0 Clear Registers
6 ENT 1
10 +/– ENT 2
4 ENT 3
23 ENT 4
12 ENT 5
ALPHA = 7
ALPHA sx = 12,04
2ndF X2 = 145
2
From the above calculations, the mean return (x) over the five-year period is 7%, the variance (X ) is 145 and
the standard deviation (sx) is 12,04. Notice that the standard deviation is the square root of the variance.

Comparing the risk of two stand-alone assets/projects

In assessing the risk of stand-alone projects, a situation may arise where there is need to compare the risk
among two stand-alone proj cts. In addition to calculating the variance and standard deviation, the coefficient
of variation (CV) may prove us ful in the decision making process. The latter measures the risk per R1 of return.

Example:
A company is conside ing two independent investment opportunities as follows:
Project A Project B
Investment capital R500 000 R500 000
Project life 1 year 1 year

Estimated cashflows
Probability Cashflow Probability Cashflow
0,25 600 000 0,25 200 000
0,50 700 000 0,50 800 000
0,25 800 000 0,25 1 000 000

Required:
Determine which investment the company should choose.

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Solution:
The calculated mean return, standard deviation and CV are as follows:
Probability Project A (R000s) Project B (R000s)
2 2
RA RA × P (RA – RA) (RA – RA) × P RB RB × P (RB – RB) (RB – RB) × P
0,25 600 150 (100) 2 500 200 50 (500) 62 500
0,50 700 350 0 0 800 400 100 5 000
0,25 800 200 100 2 500 1 000 250 300 22 500
Expected mean
2 (RA) 700 700
Variance (σ 5 000 90 000
)
Standard deviation 70,71 300
(σ)
CV (70,71 / 700) 0,10 (300 / 700) 0,43

The calculation of the expected mean return indicates that both projects yield a positive return of R700 000, or
a net value of R200 000, being the difference between the return and the investment outlay of R500 000.
The standard deviation measures the dispersion around the mean. In the ab ve example, Project A has a lower
standard deviation of R70 711, which means it has a lower risk in comparison to Project B, which has a standard
deviation of R300 000. This is indicated by the range of cash flows for Project A, which is between R600 000 and
R800 000, whereas for Project B it is between R200 000 and R1 000 000.

The company should therefore choose Project A.

In order to compare two projects with different m an valu s, one must calculate the coefficient of variation (CV)
which measures the risk per R1 of return, that is the CV standardises the risk per R1 of return. In the above
example, the CV of Project A is only 0,10, compared to a high CV of 0,43 for Project B. To obtain the CV, one
merely has to divide the standard deviation by the expected mean return.
The correct method of evaluating two separate projects or investments is to use the mean variance approach
as developed by Markowitz in 1952. This states that:
Given a choice of two projects (or portfolios) with the same return but different risk, an investor will
choose the one with the lower risk, in this case Project A.
Alternatively, where two projects (or portfolios) have the same risk but different returns, an investor will
choose the one with the higher return.

5.3 Portfolio risk and return

Most investors invest in a collection of two or more assets. Such a collection of assets held by an investor is
known as a portfolio. It is often assumed that a rational investor will build a portfolio that will give him or her
maximum possible r turns for a given risk profile remembering that the greater the returns the greater the risk.
The components of the total risk of a portfolio is the systematic (market) and unsystematic (asset specific) risk.
The former affe ts all market participants and is due to changes in economic fundamentals (e.g. interest rates,
exchange rates, inflation, consumer demand, the price of oil, etc). Systematic risk cannot be eliminated or
minimised by managerial intervention. The latter is associated with the basic functions of the organisation (e.g.
information technology, innovation, better production processes, financing, leadership, etc). Managerial
intervention can minimise this type of risk.

Two-asset portfolio risk and return

At least two shares constitute a portfolio. A two-asset portfolio is unlikely to achieve sufficient diversification of
ri k and can therefore not constitute an efficient portfolio. However, the principles being explored here are the
ame irre pective of the number of shares that comprise a portfolio. The expected return on a portfolio of two
assets is explained and calculated under section 5.2. The primary objective of this sub-section is to explore
ways of assessing the risk of a two-asset portfolio. The primary risk measures of a two-asset portfolio are the
following –
the portfolio variance; and
the portfolio standard deviation.

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The portfolio variance:

This is a measure of the risk (volatility) of a portfolio, and it takes into consideration the combination of the
variance and co-variance of each security and its proportion in that portfolio – not just the weighted average of
all security variances.
There are two variations of the formula used to calculate the portfolio variance, namely:
One that relies on the covariance of returns of the assets in the portfolio.
The other that relies on the correlation coefficient of the returns of the assets in the portfolio.

The statistical formula for the portfolio variance based on the covariance is:
2 2 2 2
2 W xσ x + W yσ + 2W W x COV
σ p = y x y xy
Where:
2
σ p = The portfolio variance
Wx and Wy = The proportions invested in Share X and Share Y respectively
2 2
σ x and σ y = The variance on shares X and Y respectively
Cov (x,y) = Covariance of X and Y

The statistical formula for the portfolio variance based on the correlation coefficient is:

2 2 2 2 2
σ p = W xσ x + W yσ y + 2WxWy Pxyσx σy

Where:
2
σ p = The portfolio variance
Wx and Wy = The proportions invested in X and Y respectively
2 2
σ x and σ y = The variance on shares X and Y respectively
σx and σy = The standard deviation on shares X and Y respectively
Pxy = The correlation coefficient on shares X and Y

The covariance:
The covariance is a multi-variable statistical measure (as opposed to single statistical measures such as the
mean, standard deviation and variance). It is a measure of the degree to which returns on two risky assets
move in tandem. A positive covariance means that asset returns move together. A negative covariance means
returns move invers ly. If share A’s return is high whenever share B’s return is high and the same can be said for
low returns, th n th se shar s are said to have a positive covariance. If share A’s return is low whenever share
B’s return is high then these stocks are said to have a negative covariance. If the covariance is zero there is no
relationship between the variables.
The statistical fo mula for the covariance is:

Cov (x,y) = Pxyσxσy

Where:
C v (x,y) = Covariance of X and Y
Pxy = Correlation co-efficient of X and Y
σx = Population standard deviation of X
σy = Population standard deviation of Y

The correlation coefficient:

In probability theory and statistics, correlation (often measured as a correlation coefficient), indicates the
strength and direction of a linear relationship between two random variables. The calculated value lies be-
tween – 1 and + 1. Although the covariance measures the degree to which returns on two risky assets move in
tandem, it does not explain the strength of the relationship.

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If x and y have a strong positive linear correlation, r (the correlation coefficient) is close to + 1. An r value of
exactly + 1 indicates a perfect positive fit. Positive values indicate a relationship between x and y variables such
that as values for x increase, values for y also increase.
If x and y have a strong negative linear correlation, r is close to – 1. An r value of exactly – 1 indicates a perfect
negative fit. Negative values indicate a relationship between x and y such that as values for x increase, values
for y decrease.
If there is no linear correlation or a weak linear correlation, r is close to 0. A value near zero means that there is
a random, nonlinear relationship between the two variables. A perfect correlation of ± 1 occurs only when the
data points all lie exactly on a straight line. If r = + 1, the slope of this line is positive. If r = – 1, the slope of this
line is negative.
The statistical formula for the correlation coefficient is:
Cov (x,y)
Pxy =
σ xσ y

Where:
Pxy = The correlation coefficient between X and Y
Cov (x,y) = Covariance between X and Y
σx = Population standard deviation of X
σy = Population standard deviation of Y

Example: Calculating the portfolio variance

Two shares offer the following four historical % returns:

Return X Return Y
20% 40%
24% 12%
10% 20%
26% 24%

Required:
Calculate the correlation coefficient of the shares.
Calculate the portfolio variance.
Calculate the portfolio standard deviation.

Solution: Cal ulating the portfolio variance (based on the correlation coefficient)
The following answer is based on the financial calculator – Sharp EL738:

Operation 1 Operation 2 Result

MODE 11 STAT 1
2ndF M – CLR 0 0 Clear Registers
20 (x,y) 40 ENT Data Set = 1
24 (x,y) 12 ENT Data Set = 2
10 (x,y) 20 ENT Data Set = 3
26 (x,y) 24 ENT Data Set = 4
RCL σx 6,16
RCL σy 10,20
RCL r (correlation coefficient) – 0,0318

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Input the calculator variables into the formula:

Operation 1 Operation 2 Result
2 2
W xσ x (0,60)(0,60) × (37,95) 13,66
2 2
W yσ y (0,40)(0,40) × (104,04) 16,65
2WxWyPxyσxσy 2(0,60)(0,40)(– 0,0318)(6,16)(10,20) – 0,96
2
σ portfolio 13,66 +16,65 – 0,96 29,35
σ portfolio Square root of 29,35 5,42
1 The correlation coefficient (r) of the shares = – 0,0318
2 The portfolio variance = 29,35
3 The portfolio standard deviation = 5,42

Interpretation:
l The correlation is negative and very weak. The variables pp se each ther but the magnitude of change of
one variable is not matched by the change in the other variable.
The standard deviation of 5,42% is an indication of the risk of the portfolio. It is only useful if compared
with the standard deviation of another portfolio or the standard deviation of the current portfolio if its
asset composition is changed.

The efficient frontier

Investors often hold a set of portfolios. For each portfolio there is need to balance the risk of the portfolio to
the expected return. Overall, the investor strives to balance the risk of all portfolios to the attendant return. To
achieve this, the investor needs to select the most efficient set of portfolios in terms of the risk – return trade-
off. The process of assessing the risk and return of a portfolio of say 50 shares or five sets of portfolios consist-
ing of 50 shares each is the same as the procedure we employed in assessing the risk and return of a two asset
portfolio. The portfolio selection process is as follows:
For any level of volatility, consider all the portfolios which have the same or similar risk. From among those
portfolios, select the one which has the highest expected return.
Alternatively, for any expected return, consider all the portfolios which have the same or similar expected
return. From among those portfolios, select the one which has the lowest risk.
As the number of shares in a portfolio or the number of portfolio sets increases, the resultant calculations
become more complex, but can be done with the aid of appropriate computer models. Calculations for analys-
ing portfolios that contain more than two shares are outside of the scope of this textbook.
The concept of the ffici nt frontier is illustrated below in Figure 5.4.

15%
Efficient portfolios curve

10%
Expected Retrn

5%
Inefficient
portfolios
(inside the curve)
0%

– 5%
0% 5% 10% 15% 20%
Risk (Return Volatility)

Figure 5.4: Graphic illustration of efficient frontier

Conclusion: An investor should select a portfolio that lies on the efficient frontier curve.

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5.4 Diversification
Diversification is a strategy designed to reduce exposure to risk by combining, in a portfolio, a variety of in-
vestments, such as stocks, bonds, and real estate, which are unlikely to all move in the same direction. The goal
of diversification is to reduce unsystematic risk in a portfolio. Volatility is limited by the fact that not all asset
classes or industries or individual companies move up and down in value at the same time or at the same rate.
Diversification reduces both the upside and downside potential and allows for more consistent performance
under a wide range of economic conditions. Mathematically, the purpose of diversification is to reduce the
standard deviation of the total portfolio. As you add securities, you expect the average covariance for the
portfolio to decline, but not to disappear since correlations are not perfect y negative. It is thought that a
portfolio of not less than 20–30 shares will approximate the market in terms of systematic risk. (Satrix’s JSE top
40). But one needs a ‘balanced’ portfolio – avoid putting one’s golden eggs in one b sket. One should structure
the portfolio so that some shares are positively correlated to the market (m rket cycles) and some are nega-
tively correlate to it in terms of returns.

Systematic versus unsystematic risk

Total risk = Market risk (systematic) + firm-specific (unsystematic) risk
Market risk (systematic): Risk that affects all players in the arket place is called ‘market risk’ or ‘systematic
risk’. Changes in economic fundamentals (interest rates, exchange rates, inflation, consumer demand, the price
of key commodities such as oil, etc.). Market risk is measured by the beta co-efficient. The market (JSE) has a
beta of 1, the market’s riskiness relative to itself. Shares/portfolios with a beta greater than 1 (say 1,2) face a
bigger risk than the market. Shares/portfolios with a b ta l ss than 1 (say 0,8) face a smaller risk than the
market.
Firm-specific risk (unsystematic): Risk associated with the basic functions of the organisation (information
technology, production processes, product-markets, innovation, financing, leadership, human skills, etc.). This
is operational/business risk. It is often assumed that management can eliminate this risk by diversification or
simply managing better.
In theory, if it were possible to eliminate firm-specific risk, the total risk facing the firm would be the market
risk. In practice, however, a firm, as a going concern, is faced with a dynamic and ever changing environment
and therefore cannot totally eliminate firm-specific risk but can minimise it.
A graphic illustration of total firm risk is shown in Figure 5.5 below.

Unsystematic risk
(Firm-specific risk)

Total risk

Standard deviation of the market

Systematic risk portfolio

Number of Shares in portfolio

Figure 5.5: Graphic Illustration of total firm risk

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5.5 The securities market line (SML)

In 1958, James Tobin expanded on the work of Markowitz, by adding a risk-free asset to the analysis. This led
to the notions of a super-efficient portfolio and the capital market line. With the aid of the risk-free asset, an
investor could be able to better portfolios on the efficient frontier. The introduction of the risk-free asset had
the following implications to an investor:
The return required of any risky asset is determined by the prevailing level of risk-free interest rates plus a
risk premium.
Investors require returns that are commensurate with the risk level they perceive.
The security market line (SML) indicates the going required rate of return on a security in the market for a given
amount of systematic risk. The SML intersects the vertical axis at the risk-free r te, indicating that any security
with an expected risk premium equal to zero should be required to e rn return equal to the risk-free rate. The
slope (gradient) of the security market line will increase or decrease with uncertainties about the future
economic outlook and/or the degree of risk aversion of investors.

Return on the security J

SML
Return on the market –
15% JSE
Risk premium
12%
B ta of security JSE
8%
Beta of security J

Risk-free return
0 1,0 1,3 Market risk = Beta
Figure 5.6: Graphic illustration of the S L (figures are imaginary)

5.6 The capital asset pricing model (CAPM)

The capital asset pricing model (CAPM) is derived from the securities market line (SML) and is based on the
concept that a security’s required rate of return is equal to the risk -free rate of return plus a risk premium that
reflects the riskiness of the security after diversification. The key components of the CAPM are the risk-free
rate of return, the beta coefficient and the market risk premium.
The following is the mathematical equation for the
CAPM: E(Ri) = Rf + βi[E(Rm) – Rf]
Where:
E(Ri) = Required rate of return on security i
Rf = Risk free rate of return
βi = Systematic risk for security i (Beta)
E(Rm) = Return on the market portfolio
E(Rm) – Rf = The risk premium

Expected return (E(Ri))

We dealt with the concept of expected return under section 5.2 above. The positioning of the investor on the
SML determines the investors’ risk and return trade off. A risk averse investor who prefers minimal or close to
zero risk has government bonds as a possible investment choice. In this situation government bonds are as-
sumed to be free of default risk. In practice, there are instances where states have defaulted on their debt (the
Russi n default of 1998 is a case in point) but the probabilities of such occurrences is negligible.
The risk-free rate of return (Rf)

This is the theoretical rate of return of an investment with zero risk. The risk-free rate represents the return an
investor would expect from an absolutely risk-free investment over a specified period of time. In theory, the

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risk-free rate is the minimum return an investor expects for any investment because he or she will not accept
additional risk unless the potential rate of return is greater than the risk -free rate. In practice, however, the
risk-free rate does not exist because even the safest investments carry a very small amount of risk. The yield
(required return) on a ten -year government bond is often used as an approximation of the risk-free rate of
[Link] risk-free rate of return is the sum of two components –
real rate of return; and
expected inflation premium.
The inflation premium compensates investors for the loss of purchasing power due to inflation.

The beta coefficient (βi)

The slope of the SML line is a measure of market risk. It relates the movement of company’s stock relative to
the market. A beta of 1 indicates that the security’s price will move with the m rket. A beta of less than 1 means
that the security will be less volatile than the market. A beta of greater than 1 indicates that the securi-ty’s
price will be more volatile than the market. For example, if a stock’s beta is 1,2, it is theoretically 20% more
volatile than the market. If the correlation between the security and the market index is negative the regres-
sion line would slope downward, and the beta would be negative. A negative beta is mathematically possible
but highly unlikely in practice (except for gold as an asset.)
The beta (β) is measured
by: COVARiM
2
SM

Where:
COVARiM = The covariance of returns of stock i with those of the market
2
SM = The variance of market returns

Example 1: Calculating the beta coefficient

The following information relates to the return of Kwangena Limited’s stock and the return on the JSE index
over a five-year period:
Year X Variable: Y Variable:
Market Return Stock Return
E(R m) E(Ri)
% %
20X1 23,8 38,6
20X2 (7,2) (24,7)
20X3 6,6 12,3
20X4 20,5 8,2
20X5 30,6 40,1

Solution: Calculating the beta coefficient

The following answer is based on the financial calculator – Sharp EL738

Operation 1 Operation 2 Result

MODE 11 STAT 1
2ndF M – CLR 0 0 Clear Registers
23,8 (x,y) 38,6 ENT Data Set = 1
– 7,2 (x,y) – 24,7 ENT Data Set = 2
6,6 (x,y) 12,3 ENT Data Set = 3
20,5 (x,y) 8,2 ENT Data Set = 4
30,6 (x,y) 40,1 ENT Data Set = 5
RCL σx 13,52
RCL σy 23,73
RCL r (correlation coefficient) 0,91

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Input the calculator variables into the formula:

Operation 1 Operation 2 Result
Cov (x,y) r σxσy 291,95
2
Variance of X σx 182,79
2 2
Variance of Y σy (S M ) 563,11
2
β Cov (x,y)/ SM (291,95/182,79) 1,60
Note: The beta can be calculated directly from the calculator by pressing RCL and “b” after imputing Data
Set 5.

Example 2: Calculating the beta coefficient

The Arjent Co wishes to purchase 100% of Murcury.
Arjent Co Murcury Market
Expected returns 10% 16% 14%
Standard deviation of returns 5% 7% 4%
Expected returns correlation with market + 0,3 + 0,6 1
The risk-free rate is 6%, while the correlation between Arjent and Murcury is + 0,1.
If Murcury is taken over, it will account for 20% of the value of the new company.
i.e. Argent = 80% Murcury = 20%

Required:
Calculate the beta for both Arjent and Murcury.
Calculate Arjent’s existing cost of equity.
Calculate the risk and return of Arjent after accepting the takeover of Murcury.
Calculate Murcury’s required return based on CAPM.

Solution:
1 Beta = covariance with the market/variance of the market

5 × 0,3
Arjent = = 0,375
4
7 × 0,6
Murcury = = 1,05
4

2 Cost of equity
ke = Rf + βi(Rm – Rf)
= 6 + 0,375 (14 – 6)
9%
3 Risk and ret rn
Return f Arjent after taking over Murcury
= (0,8 × 10% ) + (0,2 × 16%) = 11,2%
Ri k of Arjent after the takeover:

2 2
σp = 2 2
wA σA + wB σB + 2wAwBCOV(A,B)
2 2 2 2
σp = (0,8 × 5 ) + (0,2 × 7 ) + (2 × 0,8 × 0,2 × 5 × 7 × 0,1)
= 4,37

The weighted average risk for the new company is calculated as [80% × 5%] + [20% × 7%] = 5,4.

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As expected, portfolio risk (4,37%) is less than weighted average risk (5,4%), as the two companies have a
correlation of almost zero (+ 0,1) with each other.
What is interesting to note is that despite Murcury having a higher standard deviation than Arjent, once
combined, the resultant risk is less than both of their respective standard deviations.

Why?
This is significantly less than + 1 (perfect positive correlation) and hence in terms of the portfolio theory,
the combination is highly advantageous.
To reconfirm – this is due to them having an almost zero correlation with each other.

4 Murcury’s required return

Rp = Rf + βp(Rm – Rf)
= 6 + 1,05 (14 – 6) = 14,4%
Murcury
%
16
14,4

Market
Arjent

10

0 0,37 Beta 1,0 1,05

Figure 5.7: Risk/Return profile

In the above example, both Arjent and Murcury have expected returns that exceed the required return (see
Figure 5.7). Both returns will drop to the SML due to market forces until the expected return equals the re-
quired return. At the mom nt, Murcury should be accepted, as the returns are above the SML.
Risk and return for Arj nt as calculated in (iv) above will improve, but only in the very short-term. Market forces
will bring the values into equilibrium once the information is available to the market. At the present moment, A
jent should invest in Murcury, as the share value of Murcury is less than the required market value and the retu
n is above the market required return.

Equity vers s asset betas

The eq ity beta (also called geared or levered beta) is the beta of the company that takes into account the
capital structure effects (financial risk) as well as the systematic effects related to market conditions. The asset
beta (also called ungeared or unlevered beta) is the beta of the company without the effects of the capital
tructure. If one was calculating the required return for an unlisted (private) company without an equity beta,
one would have to use a ‘proxy’ beta of a similar listed company. The challenge of using the ‘borrowed’ equity
beta is that it probably comes from a company with a different capital structure from the one we are analysing.
The fo owing steps would have to be undertaken to the proxy equity beta before we can use it:
Ungear the proxy beta.
Re-gear the proxy beta.

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Ungear the proxy beta: This means removing the capital structure effects of the listed company from the
proxy beta. This turns an equity beta into an asset beta. The formula to use to ungear the equity beta is the
following
E
(β) ungeared = (β) geared × E + D(1 – t)

Where:

(β) geared The equity beta of the listed company (the borrowed/proxy beta).
(β) ungeared The asset beta of the listed company after ‘stripping’ it of its capital structure
E Equity % in listed company (40% will be s 40 only)
written
D Debt % in listed company (60% will be written s 60 only)
t The tax rate of the public company (40% will be written as 0,40).
The tax rate applies to the debt (D) only.
Regear the proxy beta: This means effecting the capital structure effects of the private company on the
asset beta calculated under 1 above. This turns the asset beta into an equity beta of the new firm. The for-
mula to use to re-gear the asset beta is the following:

E + D(1 – t)
(β) Geared = (β) ungeared ×
E

Where:
(β) geared The equity beta of the private company (target beta)
(β) ungeared The asset beta of the listed company after ‘striping’ it of its capital structure
E Equity % in private company (40% will be written as 40 only)
D Debt % in private company (60% will be written as 60 only)
t The tax rate of the private company (40% will be written as 0,40).
The tax rate applies to the debt (D) only.
After undertaking the adjustments in 1 and 2 above, the proxy beta can be used in the CAPM equation in
calculating the cost of equity (required rate of return) of the private company.

The risk premium

The risk premium is the additional return over and above the risk-free rate needed to compensate investors for
assuming an average amount of risk. Its size depends on the investors’ perceived risk of the stock market and
the investors’ degree of risk [Link] risk premium assigned by an investor to a given security in determin-
ing the required rate of r turn is a function of several different risk elements. These risk elements (premiums)
include –
maturity risk premium;
default isk p emium;
seniority isk p emium; and
marketability risk premium.

Risk premium (Rp) = Return on the market portfolio (Rm) – Risk-free return (Rf)

5.7 CAPM applications

There are a number of significant contributions of portfolio theory to the study and practice of financial man-
agement. Two of the most important of these contributions are the following:
It helps us understand the relationship between risk and return; what part of the total risk we can
manage through diversification and what part we cannot.
It is also the basis for estimating the required rate of return by equity investors (cost of equity) through the
SML and the CAPM.

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CAPM and weighted average cost of capital (WACC)

An equity investor in a company requires a return as compensation for the risk he/she bears for putting his/her
capital at the disposal of the firm. In turn the company compensates the investor for his/her capital invest-
ment. The later compensation equals the risk-free rate of return plus a risk premium as discussed under sec-
tion 5.6 above. The equity investor’s required rate of return therefore equals the firms cost of equity capital.
The CAPM is used in capital markets to define the required rate of return by equity investors and hence the
firm’s cost of equity capital.

Example: CAPM and WACC

Bulelwa Limited has 7 million ordinary shares of R1 each in issue, 5 million 6% preference shares of a par value
of R1 each, 100 000 9% semi-annual bonds with a par value of R1 000 e ch. The sh res currently sell for R30 per
share and have a beta of 1,0. The preference shares are currently selling for 110 cents per share and the bonds
have 15 years to maturity and currently sell for 89% of par. The market risk premium is 8%, the ten-year
treasury-bonds are yielding 7% and the company’s tax rate is 40%.

Required:
Calculate Bulelwa Limited’s WACC

Solution: CAPM and WACC

Calculate the required rate of return by equity hold rs (cost of quity)
Ke + Rf β(Rm – Rf) = 7% + 1,0 (8%) = 15%

Calculate the required rate of return by preference shareholders (cost of preference shares)
Kp = D/P0 = 6/110 = 5,45%

Calculate the required rate of return by bondholders (yield on the bonds)

Using the Sharp EL738:
– 890 PV
45 PMT [0,09 × R1 000/2]
30 N [15 × 2]
1000 FV
COMP I/Y
Answer: 5,23%

Calculate market valu s of funding sources:

Equity = 7m × R30 = R210m
Preferen e shares = 5m × R1,10 = R5,10m
Bonds = 100 000 × R890 = R89m

Calculate the WACC

F nding So rce Market Capital Cost of WACC
Value Structure Source
Rm % %
Equity 210,00 0,69 15,00 10,35
Preference shares 5,10 0,02 5,45 0,11
Bonds 89,00 0,29 5,23 1,52
304,10 1,00 11,98

The WACC is 11,98% (say 12%).

The calculation of the WACC was included in this section only as an illustration of the application of the CAPM
to the estimation of the cost of equity. (See chapter 4 Capital structure and the cost of capital for a detailed
analysis of these concepts.)

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CAPM and the investment appraisal decision

The discount rate for capital projects in a levered firm (has debt as part of its capital structure) is the WACC.
The use of the WACC to discount the projects in a levered firm is based on the assumption that the projects will
have the same business risk as the current portfolio of projects, meaning the project will not result in the
alteration of the existing capital structure and hence the overall financial risk. The WACC will comprise the
weighted average of the respective debt and equity components. The cost of equity could be estimated using
the CAPM. In a non-levered firm the WACC will equal the cost of equity. In the latter case, the required return
on projects will equal the required return by equity holders only.

Example: Project evaluation in a non-levered firm

A manufacturing company with a beta of 1,2 wishes to diversify into the food ret iling business.
Quoted companies involved in food retailing have a beta of 0,9.
The market required return is
18%. The risk-free rate is 9%.

Required:
Determine the rate at which the new project should be evaluated.

Solution: Project evaluation in a non-levered firm

When a company is not quoted or wishes to diversify, it is suitable to use the β of a similar quoted company in
that particular industry.
In the above example, the correct rate is calculated as:
Project required return = 9% + 0,9 (18% – 9%) = 17,1%
17,1% is the required return for any investor in this sector, based on the risk of the project relative to the
overall market, and accepting that the company is all-equity.
Note: The CAPM measures both business and financial risk through the use of the equity beta. Therefore,
shareholders in an all-equity firm are only concerned with the business risk associated with a particu-
lar industry.

Example: Project evaluation and the CAPM

Penholt Limited is considering investing R100 000 in one of two projects. Both projects have a life of one year
only and the potential return is dependent on the following economic states:
State 1 State 2 State 3
Probability 0,4 0,3 0,3
Net cash return: Proje t A R35000 R20 000 R0
Net cash return: Proje t B R5000 R30 000 R30000
Net cash etu n f om existing activities (R20000) R100 000 R300000
The company has a c rrent market value of R1 million. The Directors of Penholt believe that the risk return per
R1 of c rrent market value of their existing activities is virtually the same as those for the stock market as a
whole, incl ding general economic risk. The current risk-free rate on short-dated government investments is
10%.

Required:
Ignoring taxation, determine which of the two projects the company should accept.

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Solution:
Calculating rate of return:
State 1 State 2 State 3
*
Project A 35% 20% 0%
Project B 5%** 30% 30%
Existing operations *** 10% 30%
– 2%
* R35 000/R100 000 = 35%
** R5 000/R100 000 = 5%
*** (R20 000)/R1 000 000

Expected return and standard deviation:

Project A 0,35 × 0,4 = 0,14
0,20 × 0,3 = 0,06
0,0 × 0,3 = 0,00
0,20

Expected return 0,20 or 20% standard deviation = 0,1449

Project B 0,05 × 0,4 = 0,02
0,30 × 0,3 = 0,09
0,30 × 0,3 = 0,09
0,20

Expected return 0,20 or 20% standard deviation = 0,1225

Existing operations – 0,02 × 0,4 = – 0,008
0,10 × 0,3 = 0,03
0,30 × 0,3 = 0,09
0,112
Expected return 0,112 or 11,2%standard deviation = 0,1327
Both Projects A and B have the same expected return of 20%, with Project B having a lower risk in com-
parison to Project A.
On this basis, it would appear that Project B should be selected.
Using the CAPM model, one can evaluate Projects A and B using the formula:
Ri = Rf + βi (Rm – R f)

Calculate the beta for Projects A and B as follows:

Step 1 Calculate the ovariance for Projects A and B:

Covariance: P oject A
Use the following formula:
~ ~
(RA – A) (RO – O) P

Where:
~
R A
Project A expected return
R A Project A mean return
RO Existing operations expected return
Existing operations mean return
P Probability factor

To calculate the covariance: Project B, use the same formula as above, but replace A with B.

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Covariance: Project A:
* ****
0,15 × – 0,132 × 0,4 = – 0,00792
*****
0** × – 0,012 × 0,3 = 0
***
– 0,20 × 0,188****** × 0,3 = – 0,01128
Covariance (RA,RO) = – 0,0192
*
0,35 – 0,20 = 0,15
**
0,20 – 0,20 = 0
***
0 – 0,20 = – 0,20
****
– 0,02 – 0,112 = – 0,132
*****
0,10 – 0,112 = -0,012
******
0,30 – 0,112 = 0.188

Covariance: Project B
– 0,15 × – 0,132 × 0,4 = 0,00792
0,1 × – 0,012 × 0,3 = – 0,00036
0,1 × 0,188 × 0,3 = 0,00564
Covariance (RB,RO) = 0,0132

Step 2 Calculate beta: (note this is an alternative for ula to that shown earlier in section 5.6)
σi
βi = CORim
σm

Correlation of project A to existing operations

COV(A,O)
Correlation coefficient ρAO =
σAσO
= – 0,0192 / (0,1449 × 0,1327)
= – 0,9985

Correlation of project B to existing operations

COV(B,O)
Correlation coefficient ρBO =
σBσO
= 0,0132 / (0,1225 × 0,1327)
= 0,8120

Beta for project A

βA = (– 0,9985 × 0,1449) /0,1327 = – 1,0903

Beta for project B

βB = (0,8120 × 0,1225) / 0,1327 = 0,7496

Step 3 Calc late required return:

Pr ject A return = 0,10 + [– 1,0903(0,112 – 0,1)]
= 0,10 – 0,0131
= 0,0869 OR 8,69%
Project B return = 0,10 + 0,7496(0,112 – 0,1)
= 0,10 + 0,009
= 0,109 OR 10,90%

Conclusion:
Although Project A has the greater amount of total risk its required return is below that of Project B. Most of
the risk of Project A is eliminated due to its favourable correlation (i.e. away from + 1) with existing operations.
Project A is thus preferred as it provides a better return per R1 risk.

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Limitations in using CAPM in investment appraisal decisions

The use of CAPM in investment appraisal lies in the inherent weaknesses of the CAPM as a model for estimat-
ing the cost of equity. Some of the assumptions are as follows:
The CAPM is a single-period model. Thus, when using the rate as determined from the SML to evaluate a
project, one is assuming that the beta, risk-free rate and the expected market return will remain constant
over the life of the project.
The use of the beta as a measure of systematic risk assumes total diversification of unsystematic risk,
resulting in total risk being equal to systematic risk. In practice, firms are unab e to eliminate all unsys-
tematic risk.
The assumption that the government bonds are risk free, though l rgely true, may not be always the
case. Government bonds in some instances do carry a small amount of risk (infl tion is a case in point and
in some countries default risk).
The assumption of perfect capital market: This assumption means that all securities are valued correctly
and that their returns will plot onto the SML. In the real w rld capital markets are clearly not perfect.
When analysing projects in private companies there may be difficulties in finding suitable proxy betas,
since proxy companies very rarely undertake only one business activity.

Practice questions

Question 5–1 (Fundamental) 40 marks

An investor wishes to invest in two shares that have the following risk/return profiles:
Economic State Probability Expected return Expected return
Share A Share B
1 0,3 2% 15%
2 0,5 10% 22%
3 0,2 12% – 2%

The following information is available:

The risk-free rate is 3%.
The market return is 12%.
The standard deviation of expected market returns is 6%.
The covariance of Share A r turns with those of the market is 25,2.
The covariance of Share B r turns with those of the market is 39,6.

Required:
Calculate the expected returns for Shares A and B; the covariance of returns between the two shares, and
the correlation between Share A and Share B. (8 marks)
Determine the expected return of a portfolio consisting of 40% Share A and 60% Share B together with
the risk of the portfolio and discuss whether you would advise the investor to purchase the port-
f lio. (5 marks)
Calculate the required return for Shares A and B according to the Capital Asset Pricing Model, and discuss
whether you would advise the investor to invest in either Share A or Share B. (8 marks)
I ustrate your answer to (c) above by showing the position of Shares A and B in relation to the Securities
Market Line. (4 marks)
(e) Briefly explain why the CAPM measures return versus beta, rather than standard deviation. (8 marks)
(f) Briefly describe the limitations of using the CAPM for capital budgeting decisions. (7 marks)

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Solution 5–1
Calculate the expected returns for Shares A and B; the covariance of returns between the two shares,
and the correlation between Share A and Share B.

Share A
Probability Return 2 Variance
Mean P(return – mean)
0,3 × 2 = 2 = 10,8
0,6 0,3( 2 – 8)
2
0,5 × 10 = 5,0 0,5(10 – 8) = 2
0,2 × 12 = 2 = 3,2
2,4 0,2(12 – 8)
8,0 2 16,0
σ
σ = 4

Share B
2
Probability Return Mean P(return – mean) Variance
2
0,3 × 15 = 4,5 0,3(15 – 15,1) = 0
2
0,5 × 22 = 11,0 0,5(22 – 15,1) = 23,81
2
0,2 × –2 = – 0,4 0,2(– 2 – 15,1) = 58,48
15,1 2 82,29
σ
σ = 9,07
Expected return for investment A = 8%
Expected return for investment B = 15,1%

Covariance of returns
0,3 (2 – 8)(15 – 15,1) = 0,18
0,5 (10 – 8)(22 – 15,1) = 6,9
0,2 (12 – 8)(– 2 – 15,1) = – 13,68
Cov – 6,6

Covariance between A and B = – 6,6

– 6,6
Correlation between A and B = = – 0,1819
4 × 9,07
Determine the expected return of a portfolio consisting of 40% Share A and 60% Share B together with
the risk of the portfolio and discuss whether you would advise the investor to purchase the portfolio.

Return on portfolio
(0,4 × 8) + (0,6 × 15,1) = 12,26%

Standard deviation of portfolio

2 2 2 2
σp = wA σA + wB σB + 2wAwBCOV(A,B)

2 2
σp = 0,4 × 16 + 0,6 × 82,29 + 2 × 0,4 × 0,6 × – 6,6

σp = 2,56 + 29,62 – 3,168

5,38%

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The portfolio consists of 40% investment in Share A and 60% investment in Share B, with a return of
12,26% and a risk of 5,38%. The return is greater than the market return of 12% and the risk is lower than
the market risk of 6%.
The investor should be advised to invest in Shares A and B. Another good reason to invest in the Shares is
because they are negatively correlated; consequently there is a substantial reduction in risk per R1 re-
turn.
Note: It is impossible for an investor to get a return higher than market return with a risk lower than
market risk. The above calculations show that the expected return for the shares is probably higher
than the required return, which means that they are in temporary disequi ibrium.

Calculate the required return for Shares A and B according to the C pit l Asset Pricing Model, and
discuss whether you would advise the investor to invest in either Sh re A or Share B.

Share A
Required return
COV(RA,Rm)
βA =
2
σ m

25,2
βA = 0,7
2
6
l RA = Rf + β(RM – Rf)
l RA = 3% + 0,7(12 – 3) 9,3%
The required return for Share A is 9,3% while the expected return is only 8%. This means that the share is
in temporary disequilibrium and in the short run the return is likely to increase. The shareholder should
be advised not to purchase Share A.

Share B Required return

COV(RB,Rm)
βB =
2
σ m
1,1
39,6
βB =
2
6
l RB = Rf + β(RM – Rf) 12,9%

l The
RB requi
= 3% ed etu n for
+ 1,1(12 – 3)Share B is 12,9% while the expected return is 15,1%. This means that the share is in
tempo a y disequilibrium and in the short run the return is likely to decrease. The shareholder should be
advised to purchase Share B.

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Illustrate your answer to (c) above by showing the position of Shares A and B in relation to the Securi-
ties Market Line.

15,1 SML
B
12,9
12

% Return
9,3
A
8

0 0,7 B ta 1 1,1

(e) Briefly explain why the CAPM measures return versus beta, rather than standard deviation.
The major determinant of the required return on an asset is its degree of risk. Risk refers to the probabilities
that the returns, and therefore the values of an asset or security, may have alternative outcomes. The measure
of risk is generally accepted as the standard deviation (σ) of an asset or security.

Two types of risk are identified or associated with a security –

unsystematic (avoidable) risk; and
systematic (unavoidable) risk.
Unsystematic risk may be referred to as the internal risk of a company. It represents those financial
management, legal or worker decisions that affect the profitability of the company. An investor can
therefore reduce the unsystematic risk by holding a diversified portfolio. Empirical studies show that
most of the unsystematic risk is eliminated by portfolios consisting of as few as ten securities.
Systematic risk cannot be avoided by diversification. Systematic risk is the fundamental risk that a share’s
possible return is xpos d to, and is caused by general economic trends, political or social factors affect-ing
all companies simultaneously. Therefore, the relevant risk for an investment is the systematic risk.
The riskiness of assets or securities can be measured by their contribution to the portfolio risk. This
relationship is measured by the covariance of the security return with market returns. The CAPM is de-
veloped from portfolio theory and explains the relationship between the risk of a security and the re-q
ired risk adj stment factor.
As the market represents a portfolio of all available securities, the market return represents the average
yield with a given average systematic risk. The market is the benchmark; consequently we say that R m is
the market return, with a systematic risk factor of 1 or beta = 1. From this relationship we draw the SML,
which is a line joining the risk-free rate to the market return and beyond. All securities on the SML line are
efficient and yield a return that equates to its covariance with the market return, Rm.

Briefly describe the limitations in using the CAPM for capital budgeting decisions.
Using the rate as determined from the SML to evaluate a project means that one is assuming that the beta,
risk-free rate and expected market return will remain constant over the life of the project.
The assumptions of the CAPM model, especially ‘borrowing and lending can be made at the risk-free rate’.
At high levels of gearing, debt will not be risk free. The problem is that M and M assume that risk is

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measured entirely by variability of cashflows. At high gearing, there will be fears of bankruptcy which will
increase the cost of both debt and equity resulting in an increased WACC.
Tax implications change for different categories of investors. Tax relief is available on debt interest as long
as taxable profits are high enough. Not all companies will be able to obtain this advantage, and the proba-
bility of taxable profits being high enough decreases with increasing gearing. Therefore, at high gearing, the
debt is not so attractive. However, since capital allowances will be lower in future, there is more chance of
debt interest being advantageous, albeit at a lower company tax rate.
Risk is regarded as an increasing function over time (risk is compounded over time).
Major shareholders are institutions, some of whom are able to obtain tax re ief on borrowings (e.g. invest-
ment trusts). This removes the advantage of company borrowing.

Question 5–2 (Intermediate) 35 marks

Marine Fisheries is an established company which is looking to expand its fishing interests by purchasing a
100% interest in Shark Bait. The management of Marine Fisheries believes that the expected returns from the
acquisition of Shark Bait are dependent on the state of the econ my.
The following information is made available:
Estimated return
State of the Probability Marine Shark The
economy of occurrence Fish ri s Bait market
Favourable 0,3 16% 20% 14%
Neutral 0,4 10% 12% 8%
Unfavourable 0,3 2% 0% 6%
Book value in million 12m R8m –
Market value in million R8m R12m –
Standard deviation of returns 5,4% 7,8% 3,2%
Covariance with the market 0,0024 0,0023 –
The risk-free rate is 5% and there is no company or personal taxation.

Required:
Determine whether Marine Fisheries should acquire Shark Bait in line with the portfolio theory.
(13 marks)
Illustrate and explain what the term ‘risk premium’ means in the context of the portfolio theory and
calculate the required return for a portfolio that has the same return/risk characteristics as Marine Fisher-
ies. (8 marks)
Calculate, in line with the portfolio theory, how an investor can move along the capital market line to a
point that gives him a standard deviation equal to 6,4%. (Ignore Marine Fisheries and Shark Bait.)
(6 marks)
Determine whether Marine Fisheries and Shark Bait are a good investment in the context of the Capital
Asset Pricing Model. (8 marks)

Solution 5–2
(a) Determine whether Marine Fisheries should acquire Shark Bait in line with the portfolio theory.
Marine Fi heries expected return
State Return Expected
Mean
0,3 × 0,16 = 0,048
0,4 × 0,10 = 0,04
0,3 × 0,02 = 0,006
Mean 0,094 or 9,4%
σ 0,054 or 5,4%

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Model
Shark Bait expected return
State Return Expected
Mean
0,3 × 0,20 = 0,06
0,4 × 0,12 = 0,048
0,3 × 0 = 0
Mean 0,108 or 10,8%
σ 0,078 or 7,8%
Covariance: Marine Fisheries/Shark Bait
State Deviation Covariance
0,3 (0,16 – 0,094)(0,20 – 0,108) = 0,0018216
0,4 (0,10 – 0,094)(0,12 – 0,108) = 0,0000288
0,3 (0,02 – 0,094)(0 – 0,108) = 0,0023976
0,004248

Return: Marine Fisheries &Shark Bait combined

8* 12
× 9,4% + × 10,8% = 10,24
20 ** 20
Market value of Marine Fisheries
Combined market values of Marine Fisheries and Shark Bait

2 2 2 2
Risk = 0,4 × 0,054 + 0,6 × 078 + 2 × 0,4 × 0,6 × 0,004248
= 0,069 or 6,9%
The return of Marine Fisheries has increased by only 0,84%, while the risk has increased by 1,5%. The returns of
Marine Fisheries and Shark Bait are positively correlated; consequently one would not expect a reduction in risk.
The CV for Marine Fisheries is:
9,4

5,4 = 1,74
While that for the new company is:
10,24
= 1,48
6,9
which once again shows that Marine Fisheries offers a better return per R1 of risk.

Illustrate and explain what the term ‘risk premium’ means in the context of the portfolio theory and
calculate the required return for a portfolio that has the same return/risk characteristics as Marine
Fisheries.
Risk premium represents the required return above the risk-free rate that should be required on a portfolio
where risk is greater than zero.
It is expressed as:
σp (Rm – Rf)
σm
The required return for a portfolio with the same characteristics as Marine Fisheries is:
5,4
Rf + 3,2 (Rm – R f)
5,4
*
= 5 + 3,2 (9,2 – 5)

12,0875%

169
 Market returns = (0,30 × 14%) + (0,40 × 8%) + (0,30 × 6%) = 9,2%

CML

Risk Premium

Rf

Calculate, in line with the portfolio theory, how an investor can move along the capital market line to a
point that gives him/her a standard deviation equal to 6,4%. (Ignore Marine Fisheries and Shark Bait.)

σi
Rf + (Rm – R f)
σm
6,4
= 5 + (9,2 – 5)
3,2
= 13,4%
As the required risk is twice the market risk, an investor would have to borrow an amount equal to his/her
investment in the market portfolio at the risk-free rate and invest the whole amount in the market.
i.e. Borrow 1
Own capital 1
Invest in the market 2

Market return 9,2 × 2 = 18,4

Cost 5
Return 13,4%

Determine wh th r Marine Fisheries and Shark Bait are a good investment in the context of the Capital
Asset Pricing Mod l.
The required return for both ompanies is determined by:

ke = Rf + β (Rm – Rf)
β for Marine Fisheries β for Shark Bait
0,0024 0,0023
2 2
= 0,032 = 0,032
= 2,34 = 2,25

Marine Fisheries Shark Bait

Required return 5 + 2,34 (9,2 – 5) 5 + 2,25 (9,2 – 5)
= 14,828% = 14,45%
Expected return
= 9,4% = 10,8%
Both companies offer a return well below their required return. This means that both returns are below the
SML and are over-priced.

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Question 5–3 (Intermediate) 35 marks

Bean Ltd is a division of Earl Enterprises and has been allocated R5 million for capital expansion in the forth-
coming year. The management of Bean Ltd believes that the company must spread its risk by investing in
projects with different risk profiles and has identified two possible investments.
The capital available to Bean Ltd is sufficient to invest in only one of the projects. The following information has
been made available:
Estimated return %
Economic growth Probability of Existing
(annual average) occurrence Project 1 Project 2 investments
Zero 0,3 14 8 6
3% 0,4 10 16 12
6% 0,3 8 22 16
Book value R5m R5m R10m
Market value R5m R5m R15m
The division manager has requested the accountant to determine which f the two projects should be accepted
using the portfolio theory to make the selection.

Required:
(a) Using the above information, calculate which invest ent Bean Ltd should select in line with the portfolio
theory. (20 marks)
Identify and describe the kind of risk the manag m nt of B an Ltd wishes to spread by investing in differ-
ent investments and state whether they should be concerned about reducing such risk. (8 marks)
(c) Explain how Bean Ltd could use the CAPM to evaluate the investment options available. (7 marks)

Solution 5–3
Using the above information, calculate which investment Bean Ltd should select in line with the portfo-
lio theory.

Project 1
2
Return % Probability Return deviations (Return deviations)
× probability
14 × 0,3 = 4,2 3,4 3,468
10 × 0,4 = 4,0 – 0,6 0,144
8 × 0,3 = 2,4 – 2,6 2,028
M an 10,6 Variance 5,64
σ 2,37

Project 2
8 × 0,3 = 2,4 – 7,4 16,428
16 × 0,4 = 6,4 0,6 0,144
22 × 0,3 = 6,6 6,6 13,068
Mean 15,4 Variance 29,64
σ 5,44

Exi ting
6 × 0,3 = 1,8 – 5,4 8,748
12 × 0,4 = 4,8 ,6 0,144
16 × 0,3 = 4,8 4,6 6,348
Mean 11,4 Variance 15,24
σ 3,9

171
 Covariance Project 1 + existing

Probability Return deviations Return deviations

Project 1 Existing
0,3 × 3,4 × – 5,4 = – 5,508
0,4 × – 0,6 × 0,6 = – 0,144
0,3 × – 2,6 × 4,6 = – 3,588
Covariance = – 9,24

Covariance Project 2 + existing

0,3 × – 7,4 × – 5,4 = + 11,988
0,4 × 0,6 × 0,6 = + 0,144
0,3 × 6,6 × 4,6 = + 9,108
Covariance = + 21,24

Expected return:
Project 1 + existing investments
5 15
10,6 × + 11,4 ×
20 20
= 11,2%

Project 2 + existing investments

5 15
15,4 × + 11,4 ×
20 20
= 12,4%

Risk – Standard deviation of Projects + existing investments Project 1 +

existing investments
2 2 2 2
= w σ + w σ + 2w w COV
σp A A B B A B (A,B)

σp = 0,25 × 0,25 + 5,64 + 0,75 × 0,75 × 15,24 + 2 × 0,25 × 0,75 × –

9,24
2,34%

Project 2 + existing investments

σp = 0,25 × 0,25 + 29,64 + 0,75 × 0,75 × 15,24 + 2 × 0,25 × 0,75 × 21,24

4,29%
The ab ve calculations indicate that Project 2 offers a higher return in comparison with Project 1 and has the
effect f increasing the portfolio return from 11,4% to 12,4%. However, the risk of the new portfolio (consisting
of Pr ject 2 + existing) increases from 3,9% to 4,29%. The combination of Project 1 plus existing reduces the
return by 0,2%, but has a significant effect on reducing the overall risk to 2,34% as the covariance is negative.
The company is advised to accept Project 1 on the basis of the significant risk reductions.

Identify and describe the kind of risk the management of Bean Ltd wishes to spread by investing in
different investments and state whether they should be concerned about reducing such risk.
The major determinant of the required return on an asset is its degree of risk. Risk refers to the probabilities
that the returns, and therefore the values of an asset or security, may have alternative outcomes. The measure
of risk is generally accepted as the standard deviation (σ) of an asset or security.

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Two types of risk are identified or associated with a project –

unsystematic (avoidable) risk; and
systematic (unavoidable) risk.
Unsystematic risk may be referred to as firm specific risk. It is risk associated with the company’s func-
tions in the main areas of strategy, leadership, innovation, skills, processes, product- markets, capital
structure, etc. An investor can therefore reduce the unsystematic risk by holding a diversified portfolio.
Empirical studies show that most of the unsystematic risk is significantly reduced by portfolios consisting
of as few as ten securities.
Systematic risk cannot be avoided by diversification. Systematic risk is the fundamental risk that a share’s
possible return is exposed to, and is caused by general economic trends, po itical or social factors affect-
ing all companies simultaneously. Therefore, the relevant risk for n investment is the systematic risk.
As stated above, an investor has the ability to diversify away unsystematic risk and it is up to the investor
(not a company) to spread the investment in different companies in order to reduce his overall risk. A
company should concentrate its efforts on maximising its profits to the benefits of its shareholders.
(c) Explain how Bean Ltd could use the CAPM to evaluate the investment ptions available.
Given certain assumptions (including perfect capital markets and homogeneous investor expectations) the
CAPM states that the required rate of return on an invest ent is the risk- free rate plus a premium for system-
atic (un-diversifiable) risk expressed in terms of the market-risk pre ium. Systematic risk is measured by beta,
which relates the covariance between the expected return on the investment and expected return on the
market portfolio to the variance of the market portfolio. The model may be used in the determination of an
appropriate WACC to use as a discount rate in a capital inv stm nt. A discount rate is a rate which takes into
account the specific systematic risk of the project concerned. The model is, however, subject to criticism with
respect to its theoretical assumptions and practical application.
Bean Ltd should use the CAPM to determine the required rate of return for the two investments and compare that
return to the expected return. If the required return is lower than the expected return, the investment should be
accepted. If the required return is higher than the expected return, the investment should be rejected.

Diagrammatic illustration
If Project 1 has a beta of X and offers a return of A it should be rejected as it is below the SML. It is irrelevant
that it has a negative covariance with existing investments and that the overall risk is reduced. The CAPM
model states that at a level of systematic risk equal to X an investment must offer a return that is on the SML
line. If the investment had an expected return equal to B it should be accepted.

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Question 5–4 (Intermediate) 35 marks

United Brew Limited is considering whether to accept one of two major new investment opportunities, Pro-ject
1 and Project 2. Each project would require an immediate outlay of R400 000 and United Brew expects to raise
sufficient funds to undertake one of the projects only.
The Directors of United Brew Limited believe that returns from existing activities and from the new projects
will depend on which of three economic environments prevails during the coming year. They estimate returns
for the coming year and the probabilities of the three possible environments as follows:
A B C
Probability of environment 0,3 0,4 0,3
% % %
Returns from Project 1 25 25 –5
Returns from Project 2 0 17,5 30
Aggregate returns from existing
Portfolio of projects – 10 20 30
The Directors of United Brew Limited are of the opinion that the risk and returns per R of market value of their
existing activities are similar to those for the stock market as a wh le, including their dependence on whichever
economic environment prevails.
The current rate of return on short-term government bonds and Treasury Bills is 10% per annum.

Required:
Calculate, for Projects 1 and 2:
The covariance with the market.
The beta values.
(iii) The required returns using the CAPM model. (18 marks)
Write a brief report to the Directors of United Brew Limited showing which, if either, of the two proposed
projects should be accepted in terms of the Portfolio theory and the CAPM. Explain the CAPM principles
used in arriving at the recommendation. (17 marks)

Solution 5–4
(i) Expected rates of return from Project 1, Project 2 and the company’s existing portfolio

Environment P Project 1 Project 2 Existing portfolio

A 0,3 0,25 0 – 0,1
B 0,4 0,25 0,175 0,2
C 0,3 – 0,05 0,3 0,3
Expected return 0,16 0,16 0,14

Variance of the ma ket

This can be estimated as the variance of the company’s existing portfolio.
2
Environment P rm – rm p(rm – rm)
A 0,3 – 0,24 0,01728
B 0,4 0,06 0,00144
C 0,3 0,16 0,00768
Variance 2 0,02640
σ
Standard deviation σ 0,16248

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Covariance of project returns with the market

Project 1 Project 2
Environment (r1 – r 1) p(r1 – r1)(rm – rm) (r2 – r 2) p(r2 – r 2)(rm – rm)

P
A 0,3 0,09 – 0,00648 – 0,16 0,01152
B 0,4 0,09 0,00216 0,015 0,00036
C 0,3 – 0,21 – 0,01008 0,14 0,00672
Covariance – 0,01440 0,01860

(ii) The beta values of Projects 1 and 2

β Project 1 = Covariance (Project 1 and Market)

Market variance

– 0,01440
= 0,02640 = – 0,545

(Note that as this is a negative β Project 1 is inversely related to the rest of the market)
Covariance (Project 2 and Market)
β Project 2 =
Market variance

0,01860
= = + 0,7045
0,02640

(iii)Required rates of return on each project

Project 1 = rf + β (rm – rf)

10% – 0,545 (14% – 10%)
7,82%
Project 2 = rf + β (rm – rf)
10% + 0,7045 (14% – 10%)
12,82%

Report to Directors of United Brew Limited

TO:
FROM:
DATE:
The acceptance of Project 1, rather than Project 2 is recommended. Both projects offer an expected return of
16%, but Proje t 1 only requires a return of 7,82% on a CAPM required return basis, in comparison with Pro-ject
2 which equi es a eturn of 12,82%.

Principles involved in the investment recommendation

The recommendation that Project 1 should be undertaken is made after taking into consideration the risk and
the expected return of the two projects, and how this relates to the company’s (and the stock market’s) exist-
ing risk and expected return relationship. It is based on the principles and conclusions of the portfolio theory.
This theory, under a set of restrictive assumptions, shows that when risky investments (i.e. investments whose
outcomes are uncertain) are combined (into a portfolio), the expected return that results is a simple weighted
average of the expected returns of the individual investments. However, the risk of the resulting combinations
(measured by the standard deviation or variance of the possible returns), may be less than, or equal to, the
weighted average of the risk of the individual investments. The actual outcome depends upon the sign and the
m gnitude of the correlation coefficients of the possible returns of the combined investments.
Therefore, when considering the addition of a new investment to an existing collection of investments, the
effect of the action on the company’s overall risk level is the point of importance in determining the required
return from the new investment. As a result, the required returns from the two investment projects under

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Chapter 5 Managerial
Finance
consideration are determined not by their own overall risk levels (i.e. their standard deviations of possible
returns) but by the effect each would have (if accepted) on the overall risk level of the company.
One way of utilising this result is to divide an investment project’s overall risk level into two components, that
is, systematic and unsystematic risk. Systematic risk is, in effect, that part of an investment’s total risk which
actually affects the existing risk level of the company. Unsystematic risk is the residual part which can effective-
ly be ignored as it does not affect the company’s existing risk (it is in fact eliminated through the combining
process).
Therefore, in order to choose between the two projects, their respective levels of systematic risk have to be
found and used to estimate their required returns. These are then judged against their actual expected returns.
This procedure was carried out for the two investment projects under consideration, and it appears that both
produce an expected return above the level required by the systematic risk of e ch. However, the greatest
excess of expected return is likely to be provided by Project 1. Therefore this is deemed to be the preferred
alternative. This excess return should translate itself into an increased market price of the company’s equity
and enhance the shareholders’ wealth.
Two further points of importance need to be made to present a m re c rrect picture of the principles used when
arriving at the recommendation. Firstly, although the reas ning has been couched in terms of the rela-tionship
between project risk and the risk of the company, in truth the relationship of importance is between project
risk and general stock market risk. However, it is correct for United Brew to view the relationship in terms of
the project and the company, because the co pany’s risk and return is thought to reflect the risk and return of
the market as a whole.
The second point is that the portfolio theory is construct d und r a number of strict assumptions which may not
hold in the real world. However, its general conclusions are logically sound and probably form useful guidelines
for investment decision-making in practice. Of particular importance is the idea that an investment project’s
return should not be viewed in terms of its own overall risk level, but in terms of the effect of combin-ing it
with other investments on the overall risk of that combination.
Important: A company should only invest in projects that are in the same risk class as existing investments. It
would appear that Project 1 is in a different risk class; therefore it would be up to the shareholder
(not the company) to diversify.

Question 5–5 (Intermediate) 30 marks

The Directors of Marshall (Pty) Ltd are currently evaluating the investment in a new project and have extracted
the following information:
Marshall (Pty) Ltd Project Market

Expected returns 16,4% 28% 24%

Standard deviation of r turns 4% 6% 3%
Correlation of expected returns
with return on the market portfolio + 0,4 + 0,7
The cu ent isk-f ee rate is 8%.
The Directors of Marshall (Pty) Ltd have also established that the correlation between the returns of the project
and that of the company’s existing projects is + 0,1. If the project is accepted it would account for 10% of the
value of Marshall (Pty) Ltd after investing in the project.

Required:
Calculate the existing beta value and systematic risk of Marshall (Pty) Ltd and that of the proposed pro-
ject.
Ca culate Marshall (Pty) Ltd’s equity required return.
Calculate the company return of Marshall (Pty) Ltd after accepting the project and the standard deviation
using a two-asset portfolio formula.
Determine the project required return using the CAPM model, and briefly explain why the calculations in
(c) above appear to give conflicting project appraisal when compared to the result of using the CAPM
model.

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Solution 5–5
Calculate the existing beta value and systematic risk of Marshall (Pty) Ltd and that of the proposed
project.

correlation × σp
Beta = σm
4% × 0,4
Marshall = = 0,53
3%
6% ×
Project = 0,7 = 1,40
3%

Systematic risk
Marshall = 4 × 0,4 = 1,6%
Project = 6 × 0,7 = 4,2%

Calculate Marshall (Pty) Ltd’s equity required return.

Return = Rf + β(Rm – Rf)
= 8% + 0,53(24% – 8%) = 16,48%

Calculate the company return of Marshall (Pty) Ltd aft r accepting the project and the standard devia-
tion using a two-asset portfolio formula.
Return = (0,9 × 16,4%) + (0,1 × 28%) = 17,56%
Standard deviation of a two-asset portfolio

2 2 2 2
σm = wM σ M + wP σ P + 2w wPCOV(M,P)

Where:
M = Marshall
P = Project
W = Weighting
As the covariance of Marshall and the project is not an available one can substitute covariance for correlation
multiplied by the standard deviation of Marshall and standard deviation of the Project.

2 2 2 2
σm = 0,9 × 4 + 0,1 × 6 + 2 × 0,9 × 0,1 × 4 × 6 × 0,1

13,752
3,71%
Note: Using the CAPM, the beta of Marshall + project
= (0,9 × 0,53) + (0,1 × 1,4) = 0,617
Required return: 8% + 0,617(24 – 8) = 17,872%

Determine the project required return using the CAPM model, and briefly explain why the calculations in
(c) above appear to give conflicting project appraisal when compared to the result of using the CAPM
model.
Project required return
8% + 1,4 (24% – 8%)
30,4%

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Chapter 5 Managerial Finance

30
28 30,4
Return 28%
% Project
24 Market

16,48 Marshall

Beta 0,53 0,617 1 1,4

As one can see from (c) above, the acceptance of the n w proj ct increases the expected return from 16,4% to
17,56%, and simultaneously reduces risk from 4% to 3,71%. This would appear to make the project highly
attractive to investors in Marshall. However, the required return from the project, based on the CAPM is
30,4%. Since the project is only expected to produce a 28% return, this would indicate rejection.
How can these apparently conflicting positions be reconciled? The answer lies in the distribution between
systematic and unsystematic risk. Systematic risk is that part of the risk of a particular security (i.e. variability in
return) that can be explained in terms of movements in the market. Unsystematic risk is that part of the varia-
bility in return that is due to events specific to the individual security. The CAPM ignores unsystematic risk
because it can be eliminated by diversification.
While acceptance of the project reduces the total risk of Marshall, it does not reduce the systematic risk; on
the contrary it increases it.
This may be demonstrated as follows:
Systematic risk
Beta =
Risk of the market

Beta Marshall (pre-proj ct) = 0,53

Beta project = 1,4
Beta of Marshall post-project = 0,9 × 0,53 + 0,1 × 1,4 = 0,62
Systematic isk post-project = 3 × 0,62 = 1,86%
Systematic isk p e-project = 1,60%
Increase in systematic risk = 0,26%
Req ired increase in return = 0,26% × (24 – 8) / 3 = 1,39%
Act al increase in return = (17,56% – 16,4%) = 1,16%
The increase in return is inadequate; therefore the project should be rejected
OR Beta of Marshall post-project 0,617
Beta of Marshall pre-project 0,53
Increased Beta 0,087

Required increase in return 0,087(24 – 8) = 1,392%

Actual increase = 1,16%

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 Portfolio management and the Capital Asset Pricing Model Chapter 5

Question 5–6 (Intermediate) 30 marks

ABC (Pty) Ltd is a company operating in the retail industry in two cities within the province of Gauteng. The
company is privately owned with a staff complement of 100. The company is 60% debt funded.
DEF Ltd is a company that is also operating in the retail industry. The company is operating across South Africa
and has eight boards of directors. The company also has a staff compliment of 2 500. DEF Ltd is 80% debt
funded and has a beta of 0,7.
Additional information:
The market rate of return is 13%.
ABC (Pty) Ltd debt consists of a bank loan at 8,5% interest per annum.
Five-year Government Bonds are currently trading at 7%.
The tax rate in South Africa is 28%.

Required:
You are the FD of ABC (Pty) Ltd, and have been instructed by the MD to write a report covering the following
(show all your workings in an appendix to the report):
Calculate a suitable beta for ABC (Pty) Ltd, factoring in both financial and non-financial factors. (8 marks)
Discuss the difference between systematic and non-syste atic risks, and their impact on the beta of a
company. (5 marks)
(c) Calculate the cost of equity of ABC (Pty) Ltd. (6 marks)
(d) Calculate the weighted average cost of capital of ABC (Pty) Ltd. (6 marks)
The company has an opportunity to invest in a project yielding an annual return of 13% per annum.
Should the company embark on this project? (5 marks)

Solution 5–6
Calculate a suitable beta for ABC (Pty) Ltd, factoring in both financial and non-financial factors.
The beta of DEF would be used as a proxy beta. Since the company is a public company, has governance struc-
tures in place, a bigger staff complement than ABC and a larger foot print in terms of product markets its beta
would be lower than that of ABC.
The first step would be to ungear the beta of DEF using its own capital structure:
The formula to use is:
E
(β) ungeared = (β) g ar d ×
E + D(1 – t)
20
= 0,70 ×
20 + (80)(0,72)
= 0,18
The second step wo ld be to re-gear the beta of DEF using ABC’S capital structure:
The f rmula to use is:
E + D(1 – t)
(β) geared = (β) ungeared ×
E
40 + (60)(0,72)
= 0,18 × 40
= 0,40

179
 Discuss the difference between systematic and non-systematic risks, and
their impact on the beta of a company.
Systematic risk or market risk is risk that affects all market participants and is
measured by the beta coefficient. Economic fundamentals such as inflation,
interest rates, foreign exchange, the price of key commodities such as oil,
consumer demand, etc., contribute to systematic risk. Unsystematic risk or firm
specific risk is risk that is peculiar to an individual firm. Issues such as leadership,
innovation, capital structure, product/portfolios, production processes, skills,
etc., contribute to unsystematic risk. Systematic risk cannot be diversified away
but unsystematic risk can be diversified through managing effectively.
Theoretically, since unsystematic risk can be diversified away, total risk would
be composed of market risk which is measured by the beta. Increasing
systematic risk increases the beta. The reverse is true.

Calculate the cost of equity of ABC (Pty) Ltd.

Using the CAPM:

Ke = Rf + β (Rm – Rf)
Ke = 7% + 0,4 (13% – 7%)
Ke = 9,4%

Calculate the after tax cost of debt:

Cost of ABC bank loan = 8,5%
The tax rate = 28%
The after-tax cost of debt = 8,5% (1 – 0,28)
Kd = 6,12%

Calculate the weighted average cost of capital of ABC (Pty) Ltd.

Funding Source Proportion Cost WACC

% %
Equity 0,40 9,4 3,76
Debt 0,60 6,12 3,67
Total 1,00 7,43

The company has an opportunity to invest in a project yielding an

annual return of 13% per annum. Should the company embark on this
project?
Since the return of 13% on the project is higher than the cost of funds at 7,43,
the company should invest in the project provided the following is met:
The risk of the project is similar to the risk of the current portfolio of
projects that the company currently is invested in.
The funding of the project will not alter the capital structure of the
company. Altering the capital structure w uld pr bably increase the weighted
average cost of capital.