THE INSTITUTE OF BRAZILIAN BUSINESS AND PUBLIC MANAGEMENT ISSUES The Minerva Program - Spring 2010 The Capital Asset Pricing Model – CAPM – the Special Case of Estimating Divisional Betas By Guilherme Furst [email protected] Advisor: Prof.William C. Handorf, PhD2TABLE OF CONTENTS 1. Introduction .............................................................................................................. 3 2. Eletrobras and the Brazilian Electricity Industry ..................................................... 4 3. Project Analysis and Valuation ................................................................................ 8 3.1 The Conceptual Framework ............................................................................. 8 3.1.1 The Time Value of Money ....................................................................... 8 3.1.2 The Discount Rate .................................................................................... 8 3.2 Project Analysis ................................................................................................ 8 3.3 Valuation .......................................................................................................... 9 3.3.1 The Discounted Cash Flow .................................................................... 11 4. The Capital Asset Pricing Model (CAPM) ............................................................ 16 4.1 The Conceptual Framework ........................................................................... 16 4.2 The Model ...................................................................................................... 17 4.3 The Security Market Line (SML) ................................................................... 20 4.4 Certain aspects of the CAPM ......................................................................... 21 4.4.1 Equity risk premium ............................................................................... 22 4.4.2 Market index ........................................................................................... 22 4.4.3 Fama-French critique .............................................................................. 23 4.5 Assumptions ................................................................................................... 23 4.6 The Global CAPM .......................................................................................... 25 4.7 Extensions of the Model ................................................................................. 27 4.7.1 Multivariable approach ........................................................................... 27 5. The CAPM as an estimator of divisional betas ...................................................... 29 5.1 Pure-play approach ......................................................................................... 29 5.2 Impact of Leverage ......................................................................................... 31 5.3 Multiple-play approach .................................................................................. 32 6. Conclusions and Recommendations ....................................................................... 3431. Introduction The Capital Asset Pricing Model – CAPM is the most used method for estimating the cost of equity capital which in turn is a key element in project analysis and valuation. The attractiveness of the CAPM lies on the relative simplicity of its principles and easiness of application. The model rests on the Modern Portfolio Theory, developed by Markowitz in 1952, which states that the diversification of an investment in various assets reduces the risk of the portfolio composed by such assets. Based on the diversification concept, what really matters when an asset is valued is the marginal risk which the asset contributes to the risk of the portfolio. Furthermore, the risk of an asset can be divided in the avoidable risk (non-systematic) and the unavoidable risk (systematic, market). While the former reflects the risk of a single company, which can be eliminated by diversification, the latter cannot be avoided by diversification, since it is affected by fluctuations in the economy as a whole. In several surveys conducted in the United States1, it was found that most companies use an institutionalized single cost of capital as the required rate for project acceptance. However, when projects are not homogeneous to risk, which is clearly the case in a multi-division firm, the use of a single discount rate for the entire company is not adequate. As a consequence, this criterion will reject projects with lower returns, even when compatible with their risk, and accept projects with higher returns, without taking into account their risk in a proper manner. This selection procedure will be biased towards high returns projects, increasing (disproportionally) the risk profile of the company. Although there is widespread use of the CAPM by financial analysts and corporate managers in more developed countries, the application of the Model to emerging markets requires adjustment, since the strong assumptions related to market efficiency do not hold well. Even greater adaptations to the CAPM are necessary for 1Alves (2002)4estimating the cost of capital for a company not listed in the stock market or for a division within a company. The main focus of the current research project will be the estimation of divisional betas in order to evaluate projects or companies according to their risk. Besides the introduction, this paper is structured in five chapters. Chapter 2 shows a brief description of the procedure for granting new concessions for undertakings in power generation and transmission in the Brazilian electricity industry. That chapter also describes the activities of Eletrobras (a multi-division power group in Brazil) and the study it contracted from a consultancy to improve its capital budgeting process. This information is relevant and is the background for the discussions on valuation and the CAPM throughout this paper. Chapter 3 reviews the main concepts in project analysis and valuation. It will be shown that fundamentally there is no difference in evaluating a capital project or a stock, a security or an entire company. The methods of valuation will be described with focus on the Discounted Cash Flow (DCF) models. Chapter 4 reviews the fundamental concepts of the CAPM, its