ACCA FM (was ACCA F9) tests students' knowledge and skills in applying them as a finance manager in an organisation. One of the key topics in ACCA FM is capital asset pricing model (CAPM).
In this ACCA exam focused article, I would like to explain to you the key concepts you have to understand well for the exam.
In modern finance, capital asset pricing model (CAPM) is one of the key theories every finance fundamental textbook would discuss.
E(ri) = return required on financial asset i
Rf = risk-free rate of return
βi = beta value for financial asset i
E(rm) = average return on the capital market
Q: Which area of capital asset pricing model (CAPM) relevant?
A: CAPM is relevant under business finance. It is the model to find the cost of equity by considering systematic risk (beta) of particular financial asset.
Q: What does CAPM assume?
A: The CAPM assumes that investors hold fully diversified portfolios. This means that investors are assumed by the CAPM to want a return on an investment based on its systematic risk alone, rather than on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is therefore a measure of systematic risk.
Q: What is CAPM?
A: CAPM formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium - βi (E(rm) – Rf) – which compensates the investor for the systematic risk of the financial asset. If shares are being considered, E(rm) is the required return of equity investors, usually referred to as the ‘cost of equity’.
Another core element of CAPM is the risk factor. It can be divided into business risk and financial risk and here we would like to explain in more details as below.
In capital asset pricing model, both business and financial risk is built into the company beta. If we don't consider financial risk, we can have asset beta which we will discuss here.
ba = asset beta
βe = equity beta
βd = debt beta
Ve = market value of company’s shares
Vd = market value of company’s debt
Ve + Vd(1 – T) = after tax market value of company
T = company profit tax rate
Q: Which area of asset beta formula relevant?
A: Asset beta is relevant under business finance. It reflects business risk only as the beta value of company’s business operations without any financial risk involved.
Q: What is asset beta?
A: If a company has no debt, it has no financial risk and its beta value reflects business risk alone. The beta value of company’s business operations as a whole is called the ‘asset beta’.
Q: What is equity beta?
A: When a company takes on debt, it’s gearing increases and financial risk is added to its business risk. The ordinary shareholders of the company face an increasing level of risk as gearing increases and the return they require from the company increases to compensate for the increasing risk. This means that the beta of the company’s shares, called the equity beta, increases as gearing increases.
Q: Is asset beta increased in line with equity beta increased due to gearing is up?
A: As a company gears up, the asset beta remains constant, even though the equity beta is increasing, because the asset beta is the weighted average of the equity beta and the beta of the company’s debt.
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