Outline
The topic on CAPM on Wal-Mart deals with the investment issues in Wal-Mart shares. In this study better investment option is found out through applying the analysis of beta coefficient of different companies. The expected rate of return on Wal-Mart is found out by applying the cost of capital equation. Then a comparison is made with a portfolio investment in the shares of Sainsbury and Tesco. In order to find out the profitable investment opportunity, the beta coefficient and cost of capital of each of the investment option is analyzed as a part of the study.
Introduction
Cost of equity is the rate of return that a firm must earn on its equity capital in order to satisfy the expectations of investors. While the rate of return required by debt capital and preference share capital can be ascertained easily, the calculation of cost of equity capital is somewhat difficult because unlike the other sources the benefit expected by equity shareholders cannot be ascertained easily. To cope with this difficulty, several approaches have been proposed to ascertain the cost of equity capital. They are dividend capitalization approach, realized yield approach, capital asset pricing model, bond yield plus risk premium approach, price/earnings ratio approach, earning price plus growth rate model.
Estimated Beta coefficient of Wal-Mart
Wal-Mart is considered as a good investment because even though the company’s return on equity is in the industry average, Wal-Mart seems to be a less risky investment. This is supported by a lower beta coefficient of 0.05, and the high Price Earnings Ratio as well as the company’s expected growth rate (10.10%) is an indication of the company’s strength. Investors have belief in the company’s management and operations which is reflected in the Price Earnings Ratio and expected growth rate is easily achievable by a company like Wal-Mart and this is evidenced by the percentage change in earnings per share from 2006 to 2007 (15.54%) which is coupled with a 7.52 percentage increase in the Return on Equity over the same period.
The company is also powerfully administering its assets to provide a better return on investment; this is exemplified in the working capital management as well as turnover figures. Wal-Mart’s management is trying to professionally manage the everlasting trade-off between Risk and Return. From the above, it is clear that the management is focusing on increasing returns to shareholders while at the same time professionally managing the risk – whether it is a systematic or non-systematic.
According to CAPM concept, the non-diversifiable risk of an investment is assessed in terms of the beta coefficient. Beta is an index of the degree of responsiveness of return on an investment with market return. Beta coefficient of 1 implies that risk of the specified security is equal to the market risk. The interpretation of zero coefficient is that there is no market-related risk to the investment. A negative beta coefficient implies a relationship in the opposite direction.
CAPM in the security market context
One of the key relationships in the capital asset pricing model is security market line which is given by the following equation. Security market line is the required rate of return in the market for a given amount of systematic risk.
Ki = Rf +Bi (km-Rf)
Where Ki is the required rate of return on security i
Rf is the risk free rate of return
Bi is the beta security i
km is the rate of return on the market portfolio
The Beta coefficient of Wal Mart = 0.05
Growth rate of Wal Mart = 10.10%
Risk free rate = 6.5%
Required rate of return (Ki) = 6.5 + 0.05(10.10-6.5)
Ki = 7* 3.6 = 25.2%
Required rate of return on investment in Wal-Mart = 25.2%
The beta of Tesco:
The market data on Tesco shares reveal that its shares have a beta value of 0.59. (Tesco (TSCO), 2009).
The beta of Sainsbury:
The market data on Sainsbury shares show that its shares have a beta of 0. 78.
(Sainsbury (J) (SBRY), 2009).
“It is important to remember that high-beta shares usually give the highest returns. Over a long period of time, however, high beta shares are the worst performers during market declines (bear markets). While you might receive high returns from high beta shares, there is no guarantee that the CAPM return is realized”. (Financial Concepts: Capital Asset Pricing Model (CAPM), 2009).
High beta shares should ensure highest returns to the investors. When considering the long term return on investment, the beta shares do not assuring better return to the investors as in the period of recession it provides only minimal return. Thus it is revealed that a high beta share is not suitable for investors having long term goals on investment reruns.
When considering the beta of Sainsbury and Tesco it is revealed that their shares have a higher beta than Wal-Mart. When the shares of Sainsbury and Tesco show beta of 0.78 and 0.59 respectively, the beta of Wal-Mart shares is only 0.05.
When the investor invests 1/3 of his total investment in each of these companies, the beta of the portfolio should be as follows:
The beta of the portfolio = (0.05+ 0.59 + 0.78) / 3 = 0.47.
Expected rate of return of the portfolio: (Cost of capital) = 6.5 + 0.47 (10.10-6.5) = 25.09%.
Conclusion
The estimated beta of the portfolio is 0.47. The expected rate of return on diversified portfolio is calculated as 25.09%. While the expected rate of return on investment in Wal-Mart is 25.2%, the expected rate of return on diversified portfolio is 25.09%. It reveals that the return on diversified portfolio is only slightly lower than the return on investment in Wal-Mart. Thus, it is better to opt for portfolio investment as it reduces the risk on investment.
References
- Financial Concepts: Capital Asset Pricing Model (CAPM). (2009). Investopedia. Web.
- Sainsbury (J) (SBRY): Share prices. (2009). Digital Look. Web.
- Tesco (TSCO). (2009). Digital Look. Web.