Chapter 6 Risk And Return: Chapter 7 Corporate Valuation And

Chapter 6 Risk And Returnchapter 7 Corporate Valuation And Stock Val

Chapter 6 Risk And Returnchapter 7 Corporate Valuation And Stock Val

Chapter 6. Risk and Return Chapter 7. Corporate Valuation and Stock Valuation Finance – Week 4 Lecture Risk and Return Ever wish you could invest in the stock market and earn the same kind of returns earned by big investors like Warren Buffet? Much research has been done on the market in an attempt to pinpoint a formula or magic theory that could explain the behaviors of the market and capitalize on above average returns. Several theories exist on how the market operates.

One such theory is the efficient market hypothesis. Under the efficient market hypothesis there are three proposed forms of the market: weak, semi-strong, and strong. A weak market exists when all general market information is readily available to everyone and functions on the assumption that we cannot use past performance as an indicator of future performance. The semi-strong market assumes the market to be efficient, all public information is available to all investors, and the average investor cannot beat the market rate of return. Finally, the strong market proposes that all public and private information is reflected in the price of stocks and no one could earn anything better than the market rate of return.

The oversimplified difference between each type of market under this theory is that stocks may or may not change in price depending on the type of information available: market, private, or public. While information is readily available due to advances in technology, there is still the aspect of power. Information is power and it's hard to believe that everyone would be willing to give up or go public with all information, for example, 'insider information'. Keep in mind, this is only a hypothesis! There are several market theories.

It’s up to you to consider the theory and critically reflect on your experiences, beliefs, and what you see in the market around you to determine if you feel each theory is valid or not. Another highly debated financial concept is the Capital Asset Pricing Model or CAPM for short. CAPM is a formula used to estimate the relationship between risk and return. This formula combines two key elements: risk and the time value of money. Included in the formula is best, the expected market return, and the risk free rate of return.

The great debate, however, arises when we acknowledge the many estimates upon which this formula relies. Many feel that CAPM is not a reliable measure of return. I think the key here is that the system of evaluation we have is flawed, but not completely worthless. It isn't without its faults, but for all the criticism it receives, I haven't yet seen a new model emerge to take its place. The general notion I hear in industry is that, while not perfect, it is the best method we have available.

We must acknowledge that and use the data with a grain of salt rather than using the CAPM estimation and resulting NPV calculations as iron clad truths. It's a great tool to use as a guide but can't be relied upon to be accurate to a tenth of a penny. It’s also important to consider the risk involved with trying out a new method of evaluation. While we may be in need of something new, it does indeed carry some risk if we are wrong! Small projects may not take us too far out on a limb, but some investments require huge amounts of resources.

These are the ones we want to be sure we have done the best job possible in assessing the possible return and of course the ones we would be hesitant to evaluate using a new, untested method. CAPM is commonly used in the capital budgeting process which you will learn more about next week. Many firm's use CAPM as their general rule for cost of capital. When assessing projects, the return must be greater than the firms CAPM. I found it interesting that many feel the hurdle rate is arbitrary and weeds out otherwise profitable projects.

It does, indeed, weed out the lower profit projects, but in my experience, that's the goal! We normally have a set budget to spend but also have about four times that amount of profitable projects we would like to do. Regardless of the method we use to evaluate, there will likely be profitable projects that do not get chosen. We simply can't do them all! There are several key issues here.

First, we need something to use for a rate, this provides us a good 'guestimate' for lack of a better figure. Second, I appreciate the notion that this works particularly well when we have a range of projects to consider (aka - the capital budgeting process). When we have only one project, however, it's less accurate. When working with only one project could we go out on a limb and say it's just one - can we infuse our own common sense, feel for the accuracy, and consideration of other key factors to help us evaluate how helpful the CAPM figures are and what, if any, adjustments we need to make for risk and other factors? This would be nearly impossible to do with a long line up of projects in the capital budgeting process but if we are looking at just one special project it may be possible.

As you move through the week keep your eyes and mind open. You’ll learn lots of new information, theories, and concepts, many of which are quite debatable. Keep your mind open and question the theories you read. Do they seem valid? Which theories do your beliefs and experiences support?

Remember, that this is the half-way point in the course and you do have an assignment and the midterm to complete. Please give yourself enough time to complete your homework and take your exam. If you have any questions, please contact your instructor for assistance.

Paper For Above instruction

The concepts of risk and return are central to investment decision-making and financial management. Understanding how these elements interact is crucial for investors, financial analysts, and corporate managers alike. This essay explores the key theories and models related to risk and return, emphasizing the Efficient Market Hypothesis (EMH) and the Capital Asset Pricing Model (CAPM), their implications, critiques, and practical applications.

Risk and return are inherently linked; the fundamental premise is that higher risk should be compensated with higher potential returns. This relationship underpins many investment strategies and valuation techniques. The Efficient Market Hypothesis (EMH), proposed by Eugene Fama, posits that stock prices fully reflect all available information, making it impossible to consistently achieve returns exceeding average market returns without assuming additional risk. EMH is classified into three forms: weak, semi-strong, and strong, which differ based on the type of information reflected in stock prices.

The weak form of EMH suggests that current stock prices incorporate all historical data, implying that analyzing past prices or volume cannot predict future movement. The semi-strong form asserts that all publicly available information is already priced in, thus only private insider information could confer an advantage. The strong form claims that even private or insider information is reflected in stock prices, rendering any informational advantage null in terms of market-beating returns. While these theories emphasize the efficiency of markets, empirical evidence shows anomalies and exceptions, leading many to question the absolute validity of EMH (Malkiel, 2019).

Complementing EMH is the Capital Asset Pricing Model (CAPM), which aims to quantify the expected return of an asset based on its systematic risk measured by beta, alongside the risk-free rate and expected market return. The formula encapsulates the trade-off between risk and return, guiding investors on the appropriate return necessary for bearing specific risks. Despite widespread use, CAPM faces criticism regarding its assumptions, such as markets being perfectly efficient, investors behaving rationally, and the constancy of beta over time (Fama & French, 2004). Critics argue that empirical data often deviate from CAPM’s predictions, indicating the model's limitations.

Nonetheless, CAPM remains a valuable tool, especially in the context of capital budgeting and cost of capital calculations, as many firms rely on it to make investment decisions. For example, when evaluating projects, firms typically require the project's expected return to exceed the CAPM-derived hurdle rate. This approach helps in prioritizing projects with the greatest risk-adjusted potential for success. However, the reliance on estimates of market return and risk-free rates introduces uncertainties, making the calculations more of a guideline than an absolute truth.

Furthermore, the practical application of CAPM is more reliable when assessing multiple projects via a capital budgeting process. When considering a single project, decision-makers often incorporate intuition, experience, and other risk considerations to adjust the CAPM estimate, acknowledging its limitations. It is important to recognize that no model perfectly captures market complexities. The critique of CAPM underscores the need for continuous development of better models or supplementary methods, but until then, it remains representative of the best available estimation tools (Ross, 1976).

Understanding the debates surrounding EMH and CAPM prompts investors and analysts to approach these theories critically. While they provide foundational insights, real-world anomalies and empirical deviations highlight the importance of supplementing models with qualitative judgments and alternative analysis. For instance, behavioral finance has emerged to explain market anomalies that EMH cannot, emphasizing cognitive biases and emotions influencing investor decisions (Thaler, 2015).

In conclusion, the interaction between risk and return, as explained through theories like EMH and CAPM, forms the backbone of financial decision-making. Recognizing their strengths and limitations helps practitioners use them judiciously, balancing quantitative insights with experiential judgment. Continuous research and critical assessment are essential for improving the tools we use to navigate the complexities of financial markets.

References

• Fama, E. F., & French, K. R. (2004). The Capital Asset Pricing Model: Theory and Evidence. Journal of Economic Perspectives, 18(3), 25-46.
• Malkiel, B. G. (2019). A Random Walk Down Wall Street: The Time-Tested Strategy for Successful Investing. W. W. Norton & Company.
• Ross, S. A. (1976). The Arbitrage Theory of Capital Asset Pricing. Journal of Economic Theory, 13(3), 341-360.
• Thaler, R. (2015). Misbehaving: The Making of Behavioral Economics. W. W. Norton & Company.
• Shleifer, A. (2000). Inefficient Markets: An Introduction to Behavioral Finance. Oxford University Press.
• Fama, E. F. (1970). Efficient Capital Markets: A Review of Theory and Empirical Work. The Journal of Finance, 25(2), 383-417.
• Brealey, R. A., Myers, S. C., & Allen, F. (2019). Principles of Corporate Finance. McGraw-Hill Education.
• Lintner, J. (1965). The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets. Review of Economics and Statistics, 47(1), 13-37.
• Ingersoll, J. E. (1987). Theory of Stock Market Prices. Rowman & Littlefield.
• Jegadeesh, N., & Titman, S. (1993). Returns to Buying Winners and Selling Losers: Implications for Stock Market Efficiency. The Journal of Finance, 48(1), 65-91.