The capital asset pricing model, or CAPM, is used to price an individual security or portfolio. The general idea behind CAPM is that investors should be compensated in two
The capital asset pricing model, or CAPM, is used to price an individual security or portfolio. The general idea behind CAPM is that investors should be compensated in two ways, for the time value of their money and risk incurred. The model helps investors calculate risks and what type of return they should expect on their investment. The time money value is represented by the risk-free rate, usually a 10-year government bond yield, and compensates the investors for placing money in an investment over a period of time. That is added to the other half of the formula which represents risk. It calculates the amount of compensation the investor needs for taking on additional risk. This is done by taking a Beta, which measures a stock's volatility, and multiplies by its premium. The premium is calculated by subtracting the risk-free rate of return from the expected return of the market. For example, the expected return of a stock can be figured out in the following way using a model. If the risk-free rate is 3% the Beta or risk measure of the stock is 3 and the expected market return over the period is 11%. The stock is expected to return 27%. In short, if the expected return does not make the risk worth it, the investment should not be made.
Respond to the following questions:
- You are the chief financial officer (CFO) of a multi-physician clinic. Do you see weaknesses or strengths in the capital asset pricing model (CAPM)? Explain your response and support it with examples. Include a consideration of the small market line (SML).
- Your chief executive officer (CEO) asks you to decide between debt and equity financing. Explain which the best option is. Discuss the factors that influence your decision.
As in all assignments, cite your sources in your work and provide references for the citations in APA format.
Your initial posting should be addressed at 300-500 words
respond to 2 classmates responses to discussion
Week 4 Lecture 3.html
Capital Structure
Capital structure refers to the proportions of debt and equity carried by an organization. This is an important consideration. For example, when an economy is going into recession, there is risk in carrying a lot of debt on the balance sheet. If income goes down as a result of the economic downturn, the organization may not be able to make interest payments and risks a default. In the same circumstance, in case of equity, dividends may be reduced without incurring default risk. Most businesses, whether for profit or nonprofit, have both types of financing on the books. It is the balance between them that is an important choice managers make. Each organization must consider both the risk situation and the cost of capital and decide on the balance at any particular time. The balance may change many times as conditions change. So what is the cost of capital? That is much of the topic of study in this unit and involves the interest rate that must be paid to the lender in the case of long-term debt or the dividend in the case of equity financing. In either case, the risk premium must be added, and this is usually around 6% for a large business that is stable. Adding the interest rate to 6% gives a rough estimate of the cost of capital. For a small organization, that would be about 15%. This means that any investment has a simple hurdle rate of about 15%, that is, the net income target for the investment to break even is 15%.
The choice between debt and equity financing is one type of risk–return trade-off. The use of debt financing can leverage the return to owners or, in not-for-profit firms, the return on fund capital, but it also increases the riskiness of the business. Long-term investment method and equity investment are both used extensively in healthcare, and it would be wise for you to begin to understand these methods.
Resources:
Investopedia. (2016). Capital asset pricing model – CAPM [Video]. Available from http://www.investopedia.com/video/play/capm/
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Week 4 Lecture 2.html
Equity Financing
Long-term financing is one way of raising capital. A second way is through equity financing. Equity refers to ownership, which is raised by selling stock in your organization. In case of a nonprofit organization, donations from the community are similar to equity. Equity financing has strings attached, but these are different from those of long-term debt financing. In debt financing, you must return the money over time; in equity financing, you must give up a portion of the ownership of the organization, maybe even a major part. This means that you have given up some of the say in the management of the organization. Instead of making interest payments, you will be expected to make dividend payments. That is, the new owner or the partial owner shares the profits of the organization. An important concept involved in equity financing is constant growth. The goal of the organization is to have dividends rise every quarter and the stock of the organization price rise in lockstep with the dividends. When this happens, the growth in dividends as a percentage of stock price is zero. If the dividends rose but the stock price fell, the dividends as a percentage of the stock price would rise a great deal. As long as the financials show that the organization is sound, people would see that it is paying high dividends and would be attracted to the stock, which would cause it to rise again. A look at the Standard & Poor's 500 or other market shows that the average dividend is 2%–3%. When a stock has a dividend of 15%, it indicates a very risky organization that may be on the verge of ruin.
An important concept involved in equity financing is constant growth. The goal of the organization is to have dividends rise every quarter and the stock of the organization price rise in lockstep with the dividends. When this happens, the growth in dividends as a percentage of stock price is zero. If the dividends rose but the stock price fell, the dividends as a percentage of the stock price would rise a great deal. As long as the financials show that the organization is sound, people would see that it is paying high dividends and would be attracted to the stock, which would cause it to rise again. A look at the Standard & Poor's 500 or other market shows that the average dividend is 2%–3%. When a stock has a dividend of 15%, it indicates a very risky organization that may be on the verge of ruin.
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Week 4 Lecture 1.html
Long-Term Debt Financing
When you buy a house, you examine financing plans offered by banks and loan companies. The terms include options such as repayment over fifteen to thirty years and adjustable or fixed interest rates and may include points for origination or to buy down the rate. There are a lot of categories of closing costs. There was probably a review of your credit worthiness to determine if you could reasonably be expected to make the repayments. This area was overlooked in the housing crisis that occurred in 2008. If you build a house, there are construction terms and inspections to release funds for the builder and materials, followed by a conversion to conventional finance. There is a requirement for a loan to value down payment so that you have significant "skin in the game" or commitment to the project. All of this is true when a business finances the purchase of major equipment or construction of new facilities. However, there is another step that shows that the expense is the best one that can be made among the available alternatives, that is, the projected return is the best and the risk is the lowest. A hospital may have to decide whether to buy a new Magnetic Resonance Imaging (MRI) machine or build a new emergency room (ER) wing. It must decide which alternative will offer the most bang for the buck—the highest return—and, if it fails, not cause great harm to the financial health of the organization. While this may seem fairly straightforward from a financial perspective, realize that other executives will also want to explore the competition and the projected future of the community in terms of health and growth. The community likely has an economic development agency that has much of the information needed such as projections of businesses or colleges coming to town.
Long-term financing is one way of raising capital. A second way is through equity financing. Equity refers to ownership, which is raised by selling stock in your organization. In case of a nonprofit organization, donations from the community are similar to equity.
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Capital Asset Pricing Model
The Capital Asset Pricing Model (CAPM)is a financial framework that calculates return expected from an investment based on its overall risk in relation to the market. Although CAPM has been used extensively in finance, it has its fair share of drawback and benefits.
One of the major strengths of CAPM is it has a market-based approach, market sets prices and returns. Beta estimates vulnerability to market changes and the higher beta means higher expected returns for stocks sensitive to market movements. Major weakness of CAPM is it is based on presumptions that might not always hold true in practical contexts. It assumes constant betas throughout time and linear risk-return correlations. Consequently, it excludes other variables that could affect an asset's returns, including company-specific risks, industry variables, and macroeconomic situations. The assessment of projected returns may be limited or incorrect as a result of this restriction (Fortney, 2021).
The link between the projected return and beta of the CAPM is depicted graphically by the Small Market Line (SML). It is derived from the CAPM equation and considers the market risk premium, the beta of an asset and the risk-free rate. The predicted return on an asset can be measured against the SML as a standard. An asset is predicted to deliver better returns in comparison to its degree of systematic risk if its expected return is higher than the SML. The asset can be viewed as being underpriced in this situation. On the other hand, if an asset's projected return is lower than the SML, it may be overvalued. The amount of systemic risk means that the anticipated return on investment is lower than what the CAPM predicts.
In my opinion equity financing is the best option. One of the factors to consider is financial risk tolerance. With debt finance, money is borrowed with a fixed commitment to repay it plus interest. This raises the company's financial risk, particularly if cash flow or profitability are unsure. On the other hand, equity financing divides the risk among the owners without generating a direct financial obligation. Another factor to consider is growth and expansion plans. Equity financing could be a better option for businesses with strong growth prospects or ambitious expansion ambitions. Equity investors could be drawn in by the potential profits that come with expansion, and the extra money can be utilized to finance new endeavors or projects without the stress of debt service (Vissers, 2020).
References
Fortney, C. (2021, November 30). Take online courses. earn college credit. Research Schools, Degrees & Careers. Study.com | Take Online Courses. Earn College Credit. Research Schools, Degrees & Careers. https://study.com/learn/lesson/capm-formula-model.html
Vissers, S. (2020, January 9). The Best Medical Practice Business Loans & Financing Options. Merchant Maverick. https://www.merchantmaverick.com/medical-practice-financing-loans/
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