Comment on the postings of two of your classmates. Do you agree with their position? Why or why not?
STUDENT 1:
The Capital Asset Pricing Model (CAPM) and Arbitrage Pricing Theory (APT) are both crucial tools for evaluating the link between risk and return in investments. However, they differ in their methodology and underlying assumptions. Both models take into account the systematic risk linked to an investment, but they vary in how they handle unsystematic risk. The Capital Asset Pricing Model (CAPM) utilizes only one systematic risk element, which is the market return, to calculate the expected return of an investment (Kenton, 2023). On the other hand, the Arbitrage Pricing Theory (APT) takes into account several factors that have the potential to impact returns, such as economic indicators or variables particular to the industry. In contrast to APT, CAPM relies on the assumptions of investor rationality and market efficiency.
The suitability of the model used to assess a portfolio of assets relies on the presence and significance of factors that impact returns. If the market element is the most influential and there is little data on other pertinent factors, the Capital Asset Pricing Model (CAPM) may be more suitable due to its straightforwardness. Nevertheless, if there are numerous factors influencing returns and there is accessible data to evaluate them, the Arbitrage Pricing Theory (APT) could offer a more thorough analysis (Kenton, 2023).
The selection between CAPM and APT for a solitary investment project would rely on the project’s distinct risk variables. If the project is affected by only one systematic risk factor, the Capital Asset Pricing Model (CAPM) may be sufficient (Ross, S. A., et. al, 2021). On the other hand, if the project’s returns are affected by various circumstances, the Arbitrage Pricing Theory (APT) would provide a more detailed and comprehensive insight. For example, while investing in a technology startup, APT would take into account aspects such as technological innovation, market demand, and regulatory environment. In contrast, CAPM would solely evaluate market swings (Tuovila, 2024).
Both operating and financial leverage have an impact on a firm’s beta, which is a metric used to evaluate systematic risk. Operating leverage is derived from fixed costs, whereas financial leverage is the outcome of using debt to finance operations. Both factors contribute to an increase in a firm’s beta, as they magnify the influence of market swings on the firm’s results. Nevertheless, the impact of leverage on beta varies. Operating leverage amplifies the effect of sales fluctuations on earnings, hence increasing beta. On the other hand, financial leverage magnifies the influence of earnings movements on equity returns, leading to an increase in beta (Ross, S. A., et. al, 2021).
For a newly established company, it is advisable to exercise caution when considering the inclusion of debt in the company’s capital structure. High leverage has the potential to magnify both profits and losses, hence raising the level of risk for the company and its investors. Thus, it is recommended to first use caution in utilizing loans in order to minimize danger. Implementing this prudent strategy would probably decrease the firm’s beta and hence decrease the investors’ necessary rate of return, as it would reflect the diminished risk connected with the firm.
Conversely, for a well-established business, the utilization of debt may be more tactically advantageous. Given its demonstrated history of success and consistent cash inflows, the company is likely to be more capable of managing increased debt levels. Nevertheless, an abundance of debt has the ability to heighten risk and volatility, which in turn may result in an increase in the investors’ demanded rate of return. Hence, it is crucial for a well-established company to employ debt judiciously in order to properly manage the trade-off between risk and return.
References:
Kenton, W. (2023). What is the Capital Asset Pricing Model (CAPM)? Investopedia. https://www.investopedia.com/terms/c/capm.asp
Ross, S. A., Westerfield, R. W., Jaffe, J., & Jordan, B. (2021). Corporate finance (13th ed.). McGraw-Hill. ISBN: 9781260772388
Tuovila, A., (2024). Capital structure definition, types, importance, and examples. Information retrieved May 14, 2024 from https://www.investopedia.com/terms/c/capitalstructure.asp
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STUDENT 2:
Capital asset pricing model (CAPM) and arbitrage pricing theory
Capital asset pricing model (CAPM) and arbitrage pricing theory are used to minimize risk and receive high return rates by investors. CAPM was developed with the intent to identify appropriate asset return rates theoretically based on assumptions of risk levels. CAPM allows investors to quantify investment and market return expectations based on risk, return rates, and asset beta. Alternatively, the arbitrage pricing theory (APT) uses multiple factors to explain asset return rates theoretically regarding asset risk based on systemic risk capturing using multiple factors (Nickolas, 2021).
Similarities of CAPM and arbitrage pricing theory include the intent to increase asset return rates and minimize risk. Differences between CAPM and APT include number of assumptions and the quantifying factors of each model. CAPM has more assumptions while APT has less assumptions. APT however can be more difficult to implement in contrast to CAPM implementation. CAPM is an investor preferred model due to the model uses one factor while APT uses multiple quantifying factors. CAPM would be beneficial with multiple investment portfolio. APT would be better for single investment project due to multiple quantifying factors (Nickolas, 2021).
Capital Structure Financial Leverage
Capital structure is a combination of equity and debt that companies use to finance overall growth and operations. Equity capital consists from company shares giving shareholders some claim to future profit and cash flow. Debt arises from companies issuing loans, or issues bonds, preferred stock, common stock (Tuovila,2024). Beta measures systemic risk of portfolio or security in comparison to market. Stock beta greater than 1.0 aligns with greater volatility. Beta is used in CAPM describing systematic risk and the relationship with assets expected return. CAPM is used for risky security pricing and estimates or predicts expected returns of assets. CAPM considers cost of capital and asset risk (Kenton, 2024). The recommended debt financing for new businesses would be debt if there is little or no equity in the company. For long-established operations, equity financing would be the better option due to the amount of equity within the company.
Kenton, W. (2021). Beta: definition, calculation, and explanation for investors. Information retrieved May 14, 2024 from https://www.investopedia.com/terms/b/beta.asp
Nickolas, S., (2021). CAPM vs. arbitrage pricing theory: what’s the difference? Information retrieved May 14, 2024 from https://www.investopedia.com/articles/markets/080916/capm-vs-arbitrage-pricing-theory-how-they-differ.asp
Tuovila, A., (2024). Capital structure definition, types, importance, and examples. Information retrieved May 14, 2024 from https://www.investopedia.com/terms/c/capitalstructure.asp
