- Length: 10 pages
- Subject: Economics
- Type: Term Paper
- Paper: #28062634

The equation used in this security market line relationship is as follows:

Mathis, CAPM, par. 3)

The measure of systematic risk is considered Beta or bi while E[Ri] is equal to the expected return on asset I and Rf is the risk-free rate. E[Rm] is the expected return on the market portfolio and E[Rm] - Rf is the market risk premium for the stock. Once the Beta is known then the risk and rate of return can be found.

APT is different because not only can forecast for the long-term, it can also work for the short-term scenario. This fact makes it the better of the two theories because it gives the financial professional more tools to assess risk and the rate of return. APT does this by using a model that captures all the data. All model estimations are based wholly on the Arbitrage Pricing Theory, make no parametric assumptions, do not rely on ad hoc suppositions, do not fall prey to data mining, and are built using only the most clean and widely-available data, giving the most accurate, stable and comprehensive risk models available.

Running this model one can also calculate for medium range of return. Other things this model can perform for risk assessment take into account user needs. Risk Estimates such as Tracking Error, Value-at-Risk (VaR), forecast volatility, systematic active risk, beta to benchmark, correlation with benchmark. Normal distribution assumed for traditional measures such as tracking error, but non-normal assumptions for innovative extensions. Forecast the user can choose periods, and risk models are available with optimal forecast periods of between one week and six months. Risk decomposition can also be analyzed, including traditional position-based risk attribution, marginal contribution of factors to risk, beta to factor, and innovative decompositions, all based on any of the hundreds of explanatory factors available in APT (country, sector, currency, style, economic factors, and user-defined factors). APT carries out these calculations in a linear framework with a number of different variables. This is how different time frames can be used. This theory also allows for different market trading and in today's seamless global market this is a plus for the investor. It allows for flexibility for individuals.

Further reasoning on impossibility of arbitration portfolio creation leads to basic equation of asset pricing, which can be considered as a practical result of this theory. It is interesting to note the fact that APT equation is a generalization of CAPM equation, although the arbitration theory has been created as its alternative. According to this equation, asset value fluctuation is influenced not only by the market factor (market portfolio value), but by other factors as well, including non-market risk factors - national currency exchange rate, energy prices, inflation and unemployment rates, etc. If only one factor is considered as risk factor, market portfolio value, the equation will coincide with that of CAPM.

APT model provides for a possibility of taking into account several factors. Now asset is characterized with a number of beta parameters, each of them representing asset sensitivity to a particular factor and characterizing systematic risk associated with this factor, and, as before, residual yield E. However, now the amount of specific, not factor explained, risk has become lesser. This multi-factored model brings up many questions for the financial professional. How many factors are enough for the assessment? What if too many were used? It is absolutely clear that not all parameters available for analysis influence asset price behavior. However, it is not so easy to understand, which and how many of them do. It is not constructive to build a model of all factors available at once because insignificant factors will play a role of noise and may considerably distort any results received with the model. So it very important the financial professional understand which factors are significant to the risk and weigh them carefully against the model.

Part 2: Session Long Project

The Beta for Wal-mart stock according to Pcquote.com is 0.648 or less than 1. With Beta, risk is defined as anything being higher than 1. The fact that Wal-Mart's Beta is less than 1 is a good sign for the investor. It also leads the financial professional to believe that risk is very small if not non-existent. Risk would be a factor when picking the stock. If anything, an investor would want Wal-mart stock to diversify the portfolio. In this respect-using Beta would be a desirable method of determination. It is simple as well to look up. It assess the risk involves without going into too much detail or computations. This keeps it simple for the every day investor or the novice. Wal-mart's Beta reading also makes the company a strong stock choice.

Using Beta as method, what other two companies would one pick if Beta decided the scenario? Including Johnson and Johnson, the other two companies I chose using Beta as a method were Countrywide Financial Corporation and Microsoft. Upon looking up these Betas, I also researched other companies of interest like Nestle and Apple Computer. Both were found to be too high to consider. Nestle's was off the charts at 65.532 and Apple's was at 1.803. I chose Countrywide and Microsoft because both of Betas were relatively small reflecting potential risk at the time. Both stocks were reasonably low in price, both under $30. This makes them both desirable for an investor. Countrywide's Beta was under 1 at 0.296 and Microsoft's was slightly higher than 1 at 1.659. Obviously, Countrywide is carrying less risk right now. This fact might be influenced by the mortgage boom and lower interest rates. Also consumer confidence is higher than a year ago. In comparison, Johnson and Johnson is also a strong contender. Its Beta is at 0.123, making its risk very small. The strength of this stock may have a lot to do with the current war in Iraq and a need for first aid supplies.

According to PCQoute.com neither Target nor K-Mart have a listed Beta reading. This would make it extremely difficult to surmise risk without these criteria present. Even after digging deeper into Yahoo Finance, one is unable to find a Beta.

Module 4: CU Boxes, Inc.

There is missing information in fax provided, unable to compute NPV or IRR without Cash Flow numbers). Please Advise!!!!

CU Boxes, Inc. uses a box-making machine that needs replacement. These factors one knows. Revenues will not change if the machine is replaced. Both the present machine and the new machine will last 5 years and will have no disposal value in five years. The new machine will cost $400,000. The old machine can be disposed of right now for a disposal value of $10,000. The new machine will reduce operating costs by $100,000 per year (assume cash flows at the end of the years). Assume a required rate of return or discount rate of 9%. The paragraphs below will determine if the machine should be replaced. Is it feasible for the company and cost effect? Use Net Present Value or NPV, Internal Rate of Return or IRR, and Payback in the analysis where appropriate.

The NPV is calculated as the present value of the project's cash inflows minus the present value of the project's cash outflows. This relationship is expressed by the following formula:

Mathis, par. 2)

Conclusion

This paper explored many concepts found in finance such as present value and capital asset pricing model to name a couple. This paper explored three business models in order to better understand present value and discount rates. This paper looked at the security of equity future and more specifically Wal-Mart's performance compared with Johnson and Johnson. This paper also examined the relationship between CAPM vs. APT and discussed the method used when determining a rate of return and capital budgeting purposes.

Works Cited

Anonymous. "Risk and Return." The Economist (1991): 1-2.

APT: Risk Models and Portfolio Analytics. 22 Dec 2004 http://www.apt.com/..

Capital budgeting needs vision." Business Line. Islamabad: Jul 21, 2003. pg. 1.

Johnson and Johnson Financial Summary. Yahoo Finance. 22 Dec. 2004 http://finance.yahoo.com/q?s=JNJ&d=t..

Lefley, Frank. "Management Accounting." London: Jan…