Investment Decisions Using the Capital Asset Pricing Model Author(s): J.

Fred Weston Reviewed work(s): Source: Financial Management, Vol. 2, No. 1 (Spring, 1973), pp. 25-33 Published by: Wiley on behalf of the Financial Management Association International Stable URL: http://www.jstor.org/stable/3665097 . Accessed: 18/12/2012 14:37
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INVESTMENT DECISIONS USING THE CAPITAL ASSET PRICING

MODEL

J. FRED WESTON

Dr. Weston is Professor of Business Economics and Finance, University of California, Los Angeles. He is author and coauthor of a number of books and articles in finance.

T he Capital Asset Pricing Model permits the criteria for asset expansion decisions to be set out unambiguously and compactly. It generalizes the traditional weighted average cost of capital approach. This presentation emphasizes implementation and communication of the ideas. First, the theoretical framework is briefly summarized [3,9]. Second, an example illustrates concepts and computation procedures. Third, some practical implications are discussed.

Summary of Underlying Theory

The underlying model was set forth succinctly in an article in Financial Management by Logue and Merville [4] in Equation 1, repeated here with slight changes in notation. E(Rj) = Rf + [E(Rm)Rf] ij (1)

where E(Rj) is the expected return on a security or real investment (these concepts are treated interchangeably as claims on a future income stream). Rf is a risk-free interest rate, E(Rm) is the expected return on a broad-based market index (a portfolio of securities or real assets), and ij is a measure of

volatility of the individual security relative to market returns. tj is measured by the ratio of the covariance of the returns of the individual security with market returns divided by the variance of market returns. Equation 1 states that the expected return on an individual security or real investment is represented by a risk-free rate of interest plus a risk premium. Earlier literature did not provide a theory for the determination of the risk premium. Capital market theory shows the risk premium to be equal to the market risk premium weighted by the index of the systematic risk of the individual security or real investment. The nature of, was developed in detail by Logue and Merville [4]. For an individual security it reflects industry characteristics and management policies that determine how returns fluctuate in relation to variations in overall market returns. If the general economic environment is stable, if industry characteristics remainunchanged, and if managementpolicies have continuity, the measure of j0 will be relatively stable when calculated for different time periods. However, if these conditions of stability do not exist, the value of 3 would vary. The great advantage of Equation 1 is that all its factors other than 1f are market-wide constants. If

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3's are stable, the measurement of expected returns is straightforward. For example, the returns on the market for long periods have been shown by the studies of Fisher [2] to be at the 9%-10% level. The level of Rf has been characteristically at the 4%-5%level. Thus the expected return on an individual investment, using the lower of each of the two numbers and a F of 2, would be: E(Rj) = 4% + (9% --- 4%)2 = 14%. (la)

The higher of each of the two figures gives an E(Rj) of 15%: E(Rj) = 5% + (10% - 5%)2 = 15%. (lb)

Under the conditions just described, the basic relation expressed in Equation 1 may become a criterion for capital budgeting decisions [8]. That is, the relation in Equation 1 can be extended to apply to the expected returnE(Rj)on an individual project and its volatility measure, /3, as set forth in Equation 2: E(Rj)> Rf+ [E(Rm)Rf]

j.

(2)

In inequality 2 the market constants remain. Variables for the individual firm now become variables for the individual project by addition of an appropriate superscript. Inequality 2 expresses the condition that must hold if the project is to be acceptable. The expected return on the new project must exceed the pure rate of interest plus the market risk premium weighted by /j, the measure of the individual project's systematic risk. The general relationship is illustrated in Exhibit 1. The criterion in graphical terms is to accept all projects that plot above the market line and reject all those that plot below the market line. Managers seek to find new projects such as A and B with returns in excess of the levels required by the risk-return market equilibrium relation illustrated in Exhibit 1. When such projects are added to the firm's operations, the expected returns on the firm's common stock (at its previous existing price) will be higher than required by the market line. These "excess returns" induce a rise in price until the return on the stock E(Rj) is at an equilibrium level represented by the capital market line in Exhibit 1. A comparison with the weighted average cost of capital (WACCj) approach is also facilitated by

Exhibit 1. Illustration of the Use of Investment Hurdle Rates

E(Ri)
I

Accept

I I

*A I

Line

WACCj

1
I

I
MCCB
J

/Reject D

I I

ProjectB

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Exhibit 2. Summary of Information-Mostin Case

(1) State of world (s) (2) Subjective probability
(7T)

(3) Market return Rms

(4)

(5)

(6)

(7)

Proj. #1 -.46 -.26 .46 .00

Project rates of return Proj. Proj. #3 #2 -1.00 - .50 .00 1.00 -.40 -.20 .00 .70

Proj. #4 -.40 -.20 .60 .00

s =1 s= 2 s=3 s= 4

.1 .2 .3 .4

-.30 -.10 .10 .30

this exhibit, where the weighted average cost of capital is shown as a horizontal line extending to the right from point WACCj. If the WACC criterion is interpreted as "accept a project if E(Rj) exceeds WACCj," conflicting results may be obtained. The market price of risk (MPR) criterion would reject Project C while the WACC criterion would accept it. The opposite would exist for Project B. However, admittedly, it may be inappropriate to draw the WACC line as shown in Exhibit 1, since the weighted average cost of capital applies to a "given risk class" while the systematic risk of the firm clearly varies along the horizontal axis. The general concepts may now be illustrated more concretely.

The Mostin Company Case

In the case that follows four states-of-the-worldare considered with respect to future prospects for real growth in Gross National Product. State 1 represents a relatively serious recession, State 2 is a mild recession, State 3 is a mild recovery and State 4 is a strong recovery. The probabilities of these alternative future states-of-the-world are set forth in column 2 of Exhibit 2. Estimates of market returns and pro-

ject rates of return are set forth in the remaining columns. The Mostin Company is considering four projects in a capital expansion program. The VicePresident of Finance has estimated that the firm's weighted average cost of capital (WACC) is 12%. The Economics Staff projected the future course of the market portfolio over the estimated life span of the projects under each of the four states-of-the-world (first three columns in Exhibit 2); it recommended the use of a risk-free rate of return of 4%. The Finance Department provided the estimates of project returns conditional on the state-of-the-world (columns 4 through 7 in Exhibit 2). Each project involves an outlay of approximately $50,000. Assuming that the projects are independent and that the firm can raise sufficient funds to finance all four projects, which projects would be accepted using the WACC and MPR criteria?

Solution Procedure
In Exhibit 3 the data provided by market relationships are utilized to calculate the expected return on the market along with its variance and standard deviation. The probabilities of the future

Exhibit 3. Calculation of Market Parameters

(1) (2) (3)
TrRm

(4) Rm -E(Rm) -.40 -.20 0 .20

(5) [Rm-E(Rm) .16 .04 0 .04 2

(6) 7r[(Rm-E(Rm) .016 .008 0 .016 Var Rm = .040 om =.20

2

7
.1 .2 .3 .4

Rnm -.30 -.10 .10 .30

-.03 -.02 .03 .12 E(Rm) = 10

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Exhibit 4. Calculation of Expected Returns and Covariances for the Four Hypothetical Projects
(1) (2) (3) (4) (5) (6) (7)(8

Project number
P1

7T
.1 .2 .3 .4 -

Rj
.46 .26 .46 .00

trRj
-.046 -.052 .138 .000

[Rj-E(Rj)]
.50 .30 .42 .04

[Rm-E(Rm)]
-.40 -.20 .00 .20

[Rj-E(Rj) I [Rm-E(Rm)]
.200 -.060 .000 -.008

r[tRj-E(Rj)] [Rm-E(Rm)I
.0200 .0120 .0000 -.0032 Cov(R1,Rm) = .0288 .0480 .0280 .0000 .0480 Cov(R2,Rm)= .1400 .0240 .0160 .0000 .0400 Cov(R3,Rm)= .0800 .0200 .0120 .0000 -.0080 Cov(R4,Rm) = .0240

E(R1) = .040 P2 .1 .2 .3 .4 -1.00 - .50 0 1.00 -.10 -.10 .00 .40 -1.20 - .70 - .20 0.80 -.40 -.20 .00 .20 .480 .140 .000 .160

E(R2) = .20 P3 .1 .2 .3 .4 .40 .20 .00 + .70 E(R3)= P4 .1 .2 .3 .4 .40 .20 .60 .00 -.04 -.04 .00 .28 .20 -.04 -.04 .18 .00 .50 .30 .50 .10 -.40 -.20 .00 .20 .200 .060 .000 -.020 .60 .40 .20 .50 -.40 -.20 -.00 .20 .240 .080 .000 .100

E(R4) = .10

states-of-the-world are multiplied by the associated market returns and their products are summed to obtain the expected market return E(Rm)of 10%. The expected market return E(Rm) is used in calculating the variance and standard deviation of the market returns. This is shown in columns 4 through 6. The expected return is deducted from the return under each state, and deviations from E(Rm) in column 4 are squared in column 5. In column 6 the squared deviations are multiplied by the probabilities of each expected future state (which appear in column 1). These products are summed to give the variance of the market return. The square root of the variance is its standard deviation. A similar procedure is followed in Exhibit 4 for calculating the expected return and the covariance for each of the four individual projects. The expected return is obtained by multiplying the probability of each state times the associated forecasted return. The deviations of the return under each state from the expected return are next calculated in column 5. The deviations of the market returns from their mean are repeated for convenience. In column 8, the deviations of project returns are multiplied by the deviations of the market returns and by the probabil-

ity factors to determine the covariance for each of the four projects. In Exhibit 5, the beta for each project is calculated as the ratio of its covariance to the variance of the market return, and they are employed in Exhibit 6 to estimate the required return on each project in terms of the market line relationship. The risk-free rate of return is assumed to be 4% and market risk premium of 6%. Required returns as shown in column 2 of Exhibit 6 are deducted from the estimated returns for each individual project to derive the "excess returns." These relations are depicted graphically in Exhibit 7. The MPR criterionaccepts the projectswith positive excess returns, which appear above the MPR line. Exhibit 5. Calculation of the Betas
j3 = .0288/.04=
2 = .1400/.04= 3 = .0800/.04 0.72 3.50 2.00

4 = .0240/.04 = 0.60

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Exhibit 6. Calculation of Excess Returns

(1) Project number P1 P2 P3 P4 (2) Measurement of required return E(R1) E(R2) E(R3) E(R4) = .04 + .06(0.72) = .083 = .04 + .06(3.50)= =.04 + .06(2.00)= .250 .160 (3) Estimated return .040 .200 .200 .100 (4) Excess return -.043 -.050 .040 .024

= .04 + .06(0.60) = .076

It rejects those with negative excess returns (plotted below the MPR line). The WACC criterion as portrayed in Exhibit 7 accepts projects with returns above 12% and rejects those with returns less than 12%. The two criteria give conflicting results for Project 2 and for Project 4. It may be argued with justice that projects with different risk are in different risk classes and, therefore, the WACC line cannot be employed in this frame. This emphasizes the direct adjustments of the MPR criterion for risk differences and its development of the appropriate return-risk relations for

making a determination of whether to accept or reject an individual project.

Applications
The same calculation procedures are now applied to the data of General Motors and Chrysler in Exhibits 8 and 9. In Exhibit 8, the return on the market is first calculated. Initially, the yearly percentage change in a broadly based stock market index is calculated. To each year's percentage change

Exhibit 7. Application of the Asset Expansion CritE

E(Rio)

.24 .20 .16 .12 .08 .04 0 0.5 1.0 1.5 2.0 2.5 3.0 3.5 4.0 Project 0 J WACC
* 3

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Exhibit 8. Estimates of Market Parameters

(1) Year 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 (2) Rm*t .07 .18 (.02) .20 .16 .11 (.06) .16 .11 (.09) .82/10 E(Rm) = .082 or approximately 8%, [Rmt-E(R (3) )] (.01) .10 (.10) .12 .08 .03 (.14) .08 .03 (.17) (4) [Rmt-E(Rm)]2 .0001 .0100 .0100 .0144 .0064 .0009 .0196 .0064 .0009 .0289 .0976/9 VAR(Rm) = .0108 (5) R*f .05 .03 .03 .03 .04 .04 .04 .05 .05 .07 .43/10 est Rf = .043

*Annual rates of return on market portfolio of 500 Standard & Poor's Stock Index (including dividend yields but before individual income taxes and individual transactions costs) compiled from the Federal Reserve Bulletin, various issues. **Annual yields on 9-to-12 month U.S. government issues compiled from the Federal Reserve Bulletin, various issues.

is added the dividend yield on the same index to obtain annual return on the market (column 2). Then, in a fashion similar to that used in Exhibit 3, the variance and standard deviation of market returns are calculated. The risk-free return is calculated as an average of the risk-free returns over the previous ten-year period on 9- to 12-month U.S. government security issues. Theoretically, the use of shorter maturities would minimize the influence of price level rises. However, since these measures will be utilized to calculate expected returns on individual securities, there is good reason for calculating a risk-free return that includes the inflation influence. Exhibit 8 presents computations of a market return of 8.2%, a variance of approximately 1% and an estimated risk-free rate of 4.3%. In the next step the analysis of the individual securities-General Motors Corporation and Chrysler Corporation-is undertaken (Exhibit 9). The requisite data on stock prices and dividend yields are readily available in widely used publications and financial services. From such sources the prices(Pt) are listed in column 1. In column 2 the annual percent change in price or capital gain percentage over the previous year is calculated [(Pt/Pt_ 1)- ]. In column 3 the dividend yield is recorded. Column 4 is the sum of columns 2 and 3, representing the annual returns which are utilized to calculate an

expected return of approximately 10% for General Motors and 21% for Chrysler Corporation. On the basis of the numbers and calculations implicit in columns 5 through 7 the covariance is estimated for each company. Beta values of 1.09 for General Motors Corporation and 2.94 for the Chrysler Corporation are obtained by dividing the covariance for each of the two companies by the market variance. In Exhibit 10 the expected returns for General Motors and Chrysler are calculated by utilizing market line relations. To the risk-free return is added the market risk differential times the individual company beta, indicating a return of 8.6% for General Motors and a return of 15.8% for Chrysler. The orders of magnitude and the relations are highly plausible. Because these companies produce consumer durables with relatively high income elasticities of demand, their beta values are expected to be greater than one. The emphasis on forecasting initiated in the early 1920's along with other management qualities has apparently enabled GM to keep its beta close to one. Chrysler is a more risky security than GM. An overall required return on equity for GM in the range 9% to 11% and for Chrysler in the range of 15% to 20% seem reasonable first approximations. As is generally true, theory provides a basis for narrowing the boundaries for decisions. Analysis of additional economic and finan-

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Exhibit 9. Calculation of Betas for GM and Chrysler

General Motors Corporation (1) FP (2) 1 (3) -1 D (4) (5) (6) (7) [Rm-E(Rm)]

LPt
1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 52 48 49 52 74 90 102 87 78 81 74 ( .08) .02 .06 .42 .22 .13 ( .15) ( .10) .04 ( .09)

t.04 .05 .06 .05 .05 .05 .05 .05 .05 .06

Rt

Rjt -E(Rj)]

*[R P

E(R)I

[Rm-E(Rm)] [Rjt-E(Rj)I
.0014 (.0030) (.0020) .0444 .0136 .0024 .0280 (.0120) (.0003) .0221 .0946/8 Cov(Rj,Rm)= .0118 .0118 j = =01 1.093

( .04) .07 .12 .47 .27 .18 ( .10) ( .05) .09 ( .03) .98/10

( .14) ( .03) .02 .37 .17 .08 ( .20) ( .15) ( .01) ( .13)

(.01) .10 (.10) .12 .08 .03 (.14) .08 .03 (.17)

E(Rj)=

.098 or approximately 10% Chrysler Corporation

(1) 1959 1960 1961 1962 1963 1964 1965 1966 1967 1968 1969 15 13 12 14 33 51 54 45 44 60 44

(2) (.13) ( .08) .17 1.36 .55 .06 ( .17) ( .02) .36 ( .27)

(3) .03 .02 .02 .01 .02 .02 .04 .05 .03 .05

(4) ( .10) ( .06) .19 1.37 .57 .08 ( .13) .03 .39 ( .22) 2.12/10

(5) (.31) ( .27) ( .02) 1.16 .36 ( .13) ( .34) ( .18) .18 ( .43)

(6) (.01) .10 (.10) .12 .08 .03 (.14) .08 .03 (.17)

(7) .0031 (.0270) .0020 .1392 .0288 (.0039) .0476 (.0144) .0054 .0731 .2539/8 Cov(Rk,Rm)= .0317 3k = .0317 2 .94

E(Rk) *[Rm,E(Rm)J

.21

from column computed *[Rm-E(Rm)]4 in Exhibit 8. computed from column 4 in Exhibit 8.

cial variables then provides a basis for determination of the appropriate cost of capital (or its range) to be employed in some variant of a sensitivity analysis of outcomes.

Further Implementation Aspects

The central practical implementation problem is the calculation of the betas for individual projects or for individual divisions in a company. This may represent a problem because market price data are not available either for individual projects or for individual divisions. One approach has already been

provided in the illustrative Mostin Company Case. Estimates are required of alternative future statesof-the-world, and probabilities are attached to them which correspond to returns in the alternative future states. The prospective returns on the individual projects or divisions can be calculated in the same manner as illustrated in the Mostin Company Case. An alternative procedure can also be used as a check on the previous calculations [8]. It involves multiplying three factors: (1) the price less variable cost margin, (2) the standard deviation of the turnover of operating investment to produce the product, normalized by the standard deviation of the market returns, and (3) the correlation relation between the

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Exhibit 10. Required Return for GM and Chrysler

E(Rj) = Rf+ [E(Rm)-Rf]
fj

E(Rj) = .043 + (.082-.043) E(Rk) = .043 + (.082-.043)

1.09 = .086 GM 2.94 = .158 Chrysler

short time intervals. As Professor Myers pointed out in commenting on their article, their calculations, based on a small number of observations, will result in standard errors so large that one would not reasonably utilize such estimates in practical application [6,7].

Concluding Comments
fluctuations in the economy as a whole and the output of the individual product or division of a company. The first two relations, which are calculated as a part of planning and control analysis, are fundamental determinants of the return on investment. They represent basic elements used in implementing the du Pont system of financial planning and control [10]. The third factor properly brings in the impact of the economic environment on fluctuations in the volume of sales for individual products or divisions. The problem is somewhat more complex in planning a new product activity since historical data are not available. In this instance estimates will have to be made of the three factors described. From the pro-forma statements and budgets for the new project, sales estimates and total investment estimates can be utilized to formulate an estimate of sales turnover. Similarly, from the pro-forma income statements, a price less variable cost margin can be estimated. Covariance between the output of the product and variations in the economy is related to the concept of income elasticity. From data on income elasticity, the correlation coefficient or beta may be estimated. The effort required is similar to that involved in sales and cost forecasting. The assumptions of stability in the underlying relations will not always be met. As the characteristics of the economy change, different influences with different impacts on industries and firms vary from one time period to another. One period may be characterized by extreme monetary stringency, another by changes in tax rates, another by international factors. The firm must anticipate these broad economic changes and make the requisiteadjustments. Breen and Lerner have calculated betas for three companies over a large number of different monthly intervals [1]. They observed that the wide range in the values of the betas raised doubts about the usefulness of the concept in practical applications. Their calculations of betas for General Motors, a company used in this article for illustration, for annual time intervals over periods of 6 or more years, were very close to the calculations reported here slightly over 1. Differences resulted when their calculations involved only one or two time periods or involved relatively It should not be inferred that the procedures proposed for developing investment hurdle rates will be calculated or utilized mechanically. The methodology recommended provides another useful procedure for estimating the relevant cost of equity capital and, since leverage considerations have not been introduced, the overall cost of capital as well. Capital structure variations under leverage pose additional issues treated by Rubinstein [8]. Traditional methods of calculating the cost of equity capital have been based on either a variant of the Gordon model or regression studies. The use of the Gordon model prescribes calculating the cost of equity capital by Equation 3.
=.+ k k=D G p

(3)

Equation 3 states that the cost of equity capital is the dividend yield plus the expected growth rate of the firm. In practical application the expected growth rate is estimated by the use of historical data. Covariance is not likely to change as much as past growth rates versus future growth rates. Another alternative, of course, is to estimate a future growth rate. This would involve the same kind of forecasting required for forward-looking estimates of beta. Another method of estimating the cost of capital, the more sophisticated regression studies, involve massive data collection. Problems of defining risk class must be met. The computation proceduresmake the use of a computer essential and the task of preparing the data for computer use is time consuming. Even after such massive efforts the results are not free from considerable disagreement and also require the use of managerial judgments for application. Thus the MPR procedures involve smaller estimating difficulties and provide information on risk as well as return. Hence the MPR method provides a useful managerial aid. It is economical to develop. It is based on relevant theory. The resulting estimates cannot help but improve managerialjudgments. One great practical advantage of the market price of risk (MPR) criterion is that all but one of its statistical factors are market constants, applicable

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to all firms and to all projects. Also, since the required return is related to the project's beta, acceptance or rejection is a function of the investment's own systematic risk. By implication, application of the firm's overall cost of capital or some weighted average risk premium of the firm to individual divisions or projects with different risk characteristics is conceptually invalid. The MPR criterion also underscores Myers' demonstration that diversification can be ignored in capital budgeting decisions [5]. Under the assumptions of his model, "homemade diversification" by investors is superior to diversification by business firms. However, if there is interdependence between the returns of individual projects, these "synergies"

would have to be taken into account in the comparison of diversification by firms versus diversification by investors. A great strength of the use of the capital asset pricing model is that it extends the application of neoclassical economic theory to a broad range of financial decisions. At a minimum, it provides a general framework for clarifying the assumptions of alternative criteria that have been employed. A great practical advantage of the new financial theory is utilization of the abundance of heretoforerelatively neglected but readily available financial information such as that provided in the Standard & Poor's Summary Sheets or the summary sheets provided in Moody's Handbook of CommonStocks (quarterly).

REFERENCES
1. W.J. Breen and E.M. Lerner, "On the Use of :3 in
Regulatory Proceedings," Bell Journal of Economics and Management Science (Autumn 1972), p. 612.

6. S.C. Myers, "The Application of Finance Theory

to Public Utility Rate Cases," Bell Journal of Economics and Management Science (Spring 1972), p. 58.

2. L. Fisher, "Some New Stock-Market Indexes,"

Journal of Business (January 1966), p. 191.

7. S.C. Myers, "On the Use of / in RegulatoryProceedings: A Comment," Bell Journal of Economics and Management Science (Autumn 1972), p. 622.

3. M.C. Jensen, "Capital Markets: Theory and Evidence,"

Science(Autumn 1972),p. 357.

Bell Journal of Economics and Management

8. M.E. Rubinstein,"A Synthesisof Corporate Financial Theory," Journal of Finance (March 1973), p. 167.
9. W.F. Sharpe, Portfolio Theory and Capital Markets,

4. D.E. Logue and L.J. Merville,"FinancialPolicy and

Market Expectations," Financial Management (Summer

1972), p. 37.

New York, McGraw-HillBook Company, 1970.

5. S.C. Myers, "Procedures CapitalBudgeting for Under

Uncertainty," Industrial Management Review (Spring

1968).

10. J.F. Weston, "ROI Planningand Control: A Dynamic ManagementSystem," BusinessHorizons(August 1972),p. 35.

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