FACULTY OF BUSINESS ADMINISTRATION

BACHELOR OF BUSINESS ADMINISTRATION (HONS) FINANCE

FIN 430
INTRODUCTION TO CORPORATE FINANCE

CAPITAL ASSET PRICING

MODEL (CAPM) & WORKING
CAPITAL MANAGEMENT
PREPARED BY:

NAME ID
LUQMANUL HAKIM BIN JOHARI 2020982915
MUHAMMAD NUR AFFANDI BIN JA’AFFAR 2020970549
MUHAMMAD NAQIB BIN ZAINUDDIN 2020964523
MUHAMMAD NURIZZ HAKIM BIN RAZALI 2020974333

CLASS: JBC2422B

PREPARED FOR:
HUSNIZAM HOSIN

SUBMISSION DATE:
1st July 2020
 ACKNOWLEDGEMENT

The success and outcome of this report required a lot of guidance and assistance from
many people and we are extremely fortunate to have got this all along the completion of our
report work. Whatever we have done were only due to such guidance and we would like to
express our gratitude and appreciation to all those who gave us the possibility to complete this
report.

A special thanks to our lecturer, Sir Husnizam Hosin, whose help in stimulating
suggestions and encouragement in helping us to coordinate every tasks especially in writing
this report and also providing us all support which make completion of the report on-time was
possible and we were very grateful for all the assistance as your guidance and kind supervision
given to us throughout the course were more than helpful.

Finally, many thanks go to each of the group members, whose have given full effort in
guiding each other in achieving the goal and to maintain the progress of the works and the
report itself to be on track. We also would like to acknowledge our indebtedness and deep sense
of gratitude to all our friends whose directly and indirectly involved in the process of
completing this report.
TABLE OF CONTENTS

1.0 CAPITAL ASSET PRICING MODEL ............................................................................... 1

2.0 THE IMPORTANCE OF CAPITAL ASSET PRICING MODEL (CAPM) ...................... 3
2.1 PROBLEMS WITH CAPITAL ASSET PRICING MODEL (CAPM) ........................... 3
2.2 VALUE OF CAPITAL ASSET PRICING MODEL (CAPM) ........................................ 3
2.3 SUMMARY OF CAPITAL ASSET PRICING MODEL (CAPM) ................................. 4
3.0 WORKING CAPITAL MANAGEMENT (WCM) ............................................................. 5
3.1 DEFINITION ................................................................................................................... 5
3.2 WORKING CAPITAL POLICY ..................................................................................... 5
3.3 WORKING FINANCING STRATEGIES ....................................................................... 6
4.0 REFERENCES .................................................................................................................... 9
1.0 CAPITAL ASSET PRICING MODEL

In finance, the capital asset pricing model (CAPM) is a model used to determine a
theoretically appropriate required rate of return of an asset, to make decisions about adding
assets to a well-diversified portfolio. The Capital Asset Pricing Model (CAPM) is a model that
describe the relationship between the expected return and risk of investing in security is equal
to the risk-free return plus a risk premium which is based on the beta of that security. The goal
of the CAPM formula is to evaluate whether a stock is valued when its risk and the time value
of money are compared to its expected return. This theory was Developed by Treynor, Sharpe,
Lintner, and Mossin in the early 1960s. Below is an illustration of the CAPM concept.

Capital asset pricing model Formula

Expected Return = Risk Free Rate + (Beta x Market Risk Premium)

CAPM is calculated according to the following formula:

Ra = Rrf + [ Ba x (Rm – Rrf)]

Where:

Ra = Expected return on a security

Rrf = Risk-free rate

Ba = Beta of the security

Rm = Expected return of the market

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Expected Return

The “Ra” notation above represents the expected return of a capital asset over time,
given all the other variables in the equation. “Expected return” is a long-term assumption about
how an investment will play out over its entire life.

Risk- Free Rate

The “Rrf” notation is for the risk-free rate, which is typically equal to the yield on a 10-
year US government bond. The risk-free rate should correspond to the country where the
investment is being made, and the maturity of the bond should match the time horizon of the
investment. Professional convention, however, is to typically use the 10-year rate no matter
what, because it’s the most heavily quoted and most liquid bond.

Beta

The beta (denoted as “Ba” in the CAPM formula) is a measure of a stock’s risk
(volatility of returns) reflected by measuring the fluctuation of its price changes relative to the
overall market. In other words, it is the stock’s sensitivity to market risk. If a stock is riskier
than the market, it will have a beta greater than one. If a stock has a beta of less than one, the
formula assumes it will reduce the risk of a portfolio. For instance, if a company’s beta is equal
to 1.5 the security has 150% of the volatility of the market average. However, if the beta is
equal to 1, the expected return on a security is equal to the average market return. A beta of -
1 means security has a perfect negative correlation with the market.

Market Risk Premium

From the above components of CAPM, we can simplify the formula to reduce
“expected return of the market minus the risk-free rate” to be simply the “market risk premium”.
The market risk premium represents the additional return over and above the risk-free rate,
which is required to compensate investors for investing in a riskier asset class. Put another way,
the more volatile a market or an asset class is, the higher the market risk premium will be.

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2.0 THE IMPORTANCE OF CAPITAL ASSET PRICING MODEL (CAPM)

The CAPM formula is widely used in the finance industry. It is vital in calculating the
weighted average cost of capital (WACC), as CAPM computes the cost of equity weighted
average cost of capital is used extensively in financial industry. It can be used to find the net
present value (NPV) of the future cash flows of an investment and to further calculate its
enterprise value and finally its equity value. Using the CAPM to build a portfolio is supposed
to help an investor manage their risk. If an investor were able to use the CAPM to perfectly
optimize a portfolio’s return relative risk.

2.1 Problems with Capital Asset Pricing Model (CAPM)

There are several assumptions behind the Capital Asset Pricing Model (CAPM)
formula that have been shown not to hold in the reality. Modern financial theory rests on two
assumptions which is securities markets are very competitive and efficient that is relevant
information about the companies is quickly and universally distributed and absorbed. Secondly,
these markets are dominated by rational, risk-averse investors, who seek to maximize
satisfaction from returns on their investments. Despite these issues, the CAPM formula is still
widely used in the world because it is simple and allows for easy comparisons of investment
alternatives.

2.2 Value of Capital Asset Pricing Model (CAPM)

Considering the critiques of the CAPM and the assumptions behind its use in portfolio
construction, it might be difficult to see how it could be useful. However, using the CAPM as
a tool to evaluate the reasonableness of future expectations or to conduct comparison which
still have some value.

Imagine an advisor who has proposed adding a stock to a portfolio with a $100 share
price. The advisor uses the CAPM to justify the price with a discount rate of 13%. The advisor’s
investment manager can take this information and compare it to the company’s past
performance and its peers to see if a 13% return is a reasonable expectation.

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 Assume in the example given that the peer group’s performance over the last few years
was a little better than 10% while this stock had consistently underperformed with 9% returns.
The investment manager should not take the advisor’s recommendation without some
justification for the increased expected return.

An investor can also use the concepts from the Capital Asset Pricing Model (CAPM)
and efficient frontier to evaluate their portfolio or individual stock performance compared to
the rest of the market. For example, assume that an investor’s portfolio has returned 10% per
year for the last three years with a standard deviation of returns which is risk of 10%. However,
the market averages have returned 10% for the last three years with a risk of 8%.

The investor could use this observation to re-evaluate how their portfolio is been
constructed and which holdings may not be on the Security Market Line (SML). If the holdings
that are either dragging on returns or have increased the portfolio’s risk disproportionately can
be identified, the investor can make changes to improve returns.

2.3 Summary of Capital Asset Pricing Model (CAPM)

In conclusion, The Capital Asset Pricing Model (CAPM) uses the principles of Modern
Portfolio Theory to determine if a security is valued. It relies on assumptions about investor
behaviours, risk and return distributions, and market fundamentals that do not match reality.
However, the underlying concepts of Capital Asset Pricing Model (CAPM) and the associated
efficient frontier can help investors understand the relationship between expected risk and
reward as they make better decisions about adding securities to a portfolio.

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3.0 WORKING CAPITAL MANAGEMENT (WCM)

3.1 Definition

Working Capital Management refers to a company’s managerial accounting strategy

designed to monitor and utilize the two components of working capital which is current assets
and current liabilities and to ensure the most financially efficient operation of the company.
The primary purpose of working capital management is to make sure the company always
maintains enough cash flow to meet its short-term operating costs and short-term debt
obligations.

It involves day to day decisions regarding investment in current asset which is include
anything that can be easily converted into cash within 12 months. For examples marketable
securities, cash, inventories, and account receivables. It also involves current liabilities which
they have any obligations due within the following 12 months such as operating expenses and
long-term debt payments.

Working capital management also can improve a company’s earnings and profitability
through efficient use of its resources. The objectives of this management is to ensuring the
company has enough cash to cover its debt and minimizing the cost of money on working
capital and maximizing the return on asset investment.

3.2 Working Capital Policy

Managing working capital involves risk-return trade-off amount of current asset and
source of financing which is working capital will affect the firm’s profitability and liquidity.
There have three types of basic working capital policies: Relaxed policy, Moderate
policy and Restricted policy.
First and foremost, relaxed policy maintains large amount of current asset with
flexible credit policy. It has high liquidity and potentially low profitability from investments
due to low productivity of current assets. It also has low risk policy.
Secondly, moderate policy is mixture of relaxed and restricted policy. It has moderate
risk and return. It also invests in production assets and holds enough current assets as well.
Finally, the higher risk policy that called restricted policy. It maintains lo amount of
current assets and invest in fixed asset, which result to high profitability but low liquidity.

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3.3 Working Financing Strategies

Firm finance its current assets using working capital financing through current
liabilities that have lower cost of borrowing and shorter duration. Other than that, through long-
term financing which is it has contra with current liabilities.

Working capital have three financing strategies such as maturity matching approach,
aggressive approach, and conservative approach.

Firstly, maturity matching approach is the strategies that matches the maturity of
the assets with the maturity of the financing. The firm use temporary financing to finance
temporary current assets and permanent financing to finance permanent assets. The results also
in moderate risk and returns.

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 An aggressive approach is most risky among working capital financing strategies. It
doesn’t assume to hold any reserves to cover spontaneous needs in working capital. It means
that only some portion of permanent working capital is financed by long-term financing. The
rest and the temporary working capital, including seasonal fluctuations, are met by short-term
borrowing. Adopting this approach makes it possible to reduce interest expense and increase
profitability of a business, but it also carries the greatest risk. The main drawback of an
aggressive approach is that businesses need to access short-term borrowing frequently to
recover both the portion of permanent working capital and temporary working capital. As a
result, the exposure to refinancing risk increases sharply, and businesses become vulnerable to
any interruption in accessing short-term borrowing. The advantage of this working capital
financing strategy is that short-term financing is mostly cheaper compared with long-term
financing, which allows a reduction in interest expense. Such an approach, however, violates
the matching principle, which states that noncurrent assets and permanent working capital
should be financed by long-term financing.

Finally, A conservative approach has the lowest risk and lowest profitability among
other working capital financing strategies. Businesses use long-term financing to fund not only
non-current assets and permanent working capital but also some portion of temporary working
capital. This approach is also inherent in low liquidity risk because of excessive cash. Under a
conservative approach, even a portion of temporary working capital is covered by long-term
financing, and only an emerging need for funds is met by short-term financing. It also happens
that businesses have an excessive cash balance, which should be invested in marketable

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securities. Such investments are able to be sold at any time to cover the emerging need for
working capital. The advantages of a conservative approach are the lowest reinvestment and
interest rate risk among the other working capital financing strategies. Moreover, it results in a
higher level of liquidity and solvency, so such businesses can easily access short-term
borrowing to cover emerging needs in working capital. Lowest risk, however, also results in
lowest profitability because long-term financing usually has a higher cost than short-term
financing. Funding temporary working capital by long-term financing also leads to the fact that
businesses have interest expenses even when they do not have any need for temporary working
capital.

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4.0 REFERENCES

CFI, 25 June 2020, “Capital Asset Pricing Model (CAPM) A method for calculating the
required rate of return, discount rate or cost of capital”, Retrieved from
https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-capm-formula/

CFI, 25 June 2020, “What is WACC , it's formula, and why it's used in corporate finance”,
Retrieved from https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-
wacc-formula/

Eagle Business Credit, 25 June 2020, “3 Strategies of Working Capital Financing”, Retrieved
from https://www.eaglebusinesscredit.com/blog/3-strategies-of-working-capital-financing/

Investopedia, 25 June 2020, “What Is the Capital Asset Pricing Model?” Retrieved from
https://www.investopedia.com/terms/c/capm.asp