T ANSWERS Explain the CAPM What are the conditions underlyin

T ANSWERS: Explain the CAPM What are the conditions underlying the constant growth stock valuation? (5) Why is cost of capital concept critical for financial managers? (5) What is the reinvestment rate assumption behind the IRR calculations? Why is MIRR considered an improvement over IRR? (5) model to someone not familiar with any finance. (5)

Solution

CAPM model: . When we invested some amount in a asset/portfolio/security/project, then we also expect to generate some return from that investment. If this expectation is based on risk, then this is called Capital Asset Pricing Model.It is a method/model for calculation of required return from an investment.As per CAPM theory, the expected return of a particular security or a portfolio is equal to the rate on a risk-free security plus a risk premium. If the security or portfolio does not either meet or exceed the required return, then the investment should not be entered into.

Expected Return = RF Rate + (Market Return – RF Rate)*Beta

Constant growth stock valuation:It is a stock valuation method that calculates a stock’s intrinsic value, regardless of current market conditions.

Intrinsic Value = D1 / (k – g)

where,

D1 = expected annual dividend per share for the following year,

k = required rate of return,

g = expected dividend growth rate.

Conditions:

?Cost of Capital: Every company has figure out plan for financing the business at an early stage. The cost of capital thus becomes a critical factor in deciding which financing track to follow — debt, equity or a combination of the two.So it is very important for a financial manager to evaluate cost of capital correctly. Cost of capital is the required return necessary to make a capital budgeting project, such as building a new factory, worthwhile. Cost of capital includes the cost of debt and the cost of equity.

IRR: % earning in compounding term available from project is known as IRR, used in capital budgeting to estimate the profitability of potential investments. Internal rate of return is a discount rate that makes the net present value (NPV) of all cash flows from a particular project equal to zero.

MIRR: Modified internal rate of return is used when intermediate period inflows will be reinvested at specified rate (other then IRR) then the return of a project will be MIRR.assumes that positive cash flows are reinvested at the firm\'s cost of capital, and the initial outlays are financed at the firm\'s financing cost.

MIRR is a improvement over IRR because traditional internal rate of return (IRR) assumes the cash flows from a project are reinvested at the IRR. The MIRR more accurately reflects the cost and profitability of a project.