Capital Asset Pricing Model And Beta

Published Date: 02 Nov 2017

Case Study

Henkel AG

Table of contents

Introduction……………………………………………………………1

Company assessment…………..…………………………………2

Henkel financial issues…………………………………………….3

References………………………………………………………………4

Introduction

Henkel A.G. is a successful company with a leading brands and technology in three business areas; Laundry and Home care, Beauty care and adhesive technologies. The company wants to leverage the full potential in their product categories in order to gain shares and thus to outperform their competitors and expand in emerging market. The following sections of the study, the company assessment will be discussed with emphasis on cost of equity, cost of capital, risk free rate, market rate, beta, capital asset pricing model (CAPM) and the treasury rate at which maturity is most appropriate to use in valuing the company. The company corporate beta (unlevered and lever) will be determined. The study will examine the company financial issues i.e. capital structure, marginal tax, cost of debt that Henkel is using to assess its businesses

Company assessment

i) The cost of equity is the rate of return required by a shareholder and is calculated in two different ways either by dividend valuation model or by capital asset pricing model. In order to calculate the cost of equity, the components risk free rate, market rate and beta must be determined. Seoki L. and Arun U. (2008) summarised that, the cost of equity capital is the expected return to investors, and investors would not buy a security if their expected return on that particular security is below the risk free rate because they can achieve the return at risk free rate without any risk.

Risk free rate.

The risk free rate is defined as the return on a portfolio or security that has no covariance with the market (represented by CAPM beta of 0).Is a highly used method for estimating the cost of equity capital. To estimate the risk free rate it’s important to consider government default-risk free bonds since government bonds come in many maturities. The risk free rate reflects three components; the rental rate, inflation, and maturity risk or investment rate risk which are all economic factors that are found in the yield to maturity for any given maturity length.

Market rate of return.

This is the minimum return required by investors at every level of investment risk. Instead of using the return from the market most economists prefer to use the equity risk premium which is the difference between the return from the capital market and the risk free rate of return. As it represents the extra return required for investing in equity rather than investing in risk free assets.

Beta

This is an indirect measure which compares the systematic risk associated with the company’s shares with the systematic risk of the capital market as a whole. Beta can also be describe as an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a whole. If the beta value of a company is 1, then the systematic risk with the share is the same as the systematic risk of the capital market as a whole. Beta is determined by applying CAPM on regression analysis to compare the return on a share with the returns on the capital market. Eugene F. (1994) argued that a stock’s beta is a measure of the stock’s market risk and also measures the extent to which the stock’s returns move relative to the market. Pettengill et al. (1995) summarised a conditional relationship between beta and realised returns by separating periods of positive and negative market excess return and found a significant positive relationship between beta and realized returns when market access return are positive and a significant negative relationship between beta and realized returns when market access returns are negative.

To calculate cost of capital that most companies use in investment appraisal, the WACC is used but however WACC is only applicable when companies undertaking project that are similar to their activities. When a company decides to diversify i.e. operate in a business which is different from its current operation, the CAPM must be used before calculating WACC. This is in order to remove the financial risk of a company whose beta will be considered.

The CAPM is a method of calculating the required return on investment based on an assessment of its risk. Eugene F.B. (1994) argued that CAPM is a model used in estimating the cost of retained earnings. To use CAPM in a financial system, the risk free rate of return (the yield on short government debt) will change depending on which country’s capital market is being considered.

In considering Henkel A.G. on which maturity and treasury rate is appropriate to value it company. Looking at yield to maturity for US and German treasury rate, the rate 3.38 and maturity 10years is appropriate. The reason being that when valuing European companies is important to consider 10years German bond since German bond have higher liquidity and lower credit risk than bond of other European countries. Furthermore the bond yield is in same currency as Henkel’s cash flow. Is worth to note that as of 2009 10years US treasury bonds were trading at 3.9 per cent and the German zero coupon bond were trading at 3.38 per cent.

ii) Capital Asset Pricing Model (CAPM) and Beta

Capital asset pricing model is an instrument used in measuring relative risk. The approach to CAPM is the adoption of portfolio theory by investors. The idea behind portfolio theory is that an investor may reduce risk with no impact on return as a result of holding a mix of investment. This theory introduces two types of risk associated with a company, systematic and unsystematic risk. According to Eugene F. Fama and Kenneth R. French (2004), the attraction of the CAPM is that it offers powerful and intuitively pleasing predictions about how to measure risk and the relation between expected return and risk.

Company proxy betas

In order to find a project specific discount rate using CAPM, It is important first to obtain the information on the companies with business operations similar to those of the propose investment project. These companies are referred to as proxy companies. Since their equity betas will represent the business risk of the proxy company’s business operations, they are referred to as proxy equity betas which represent the business risk of the proposed investment project.

Business risk and Financial risk.

The systematic risk represented by equity beta has both business and financial risk .In order to start calculating the project specific discount rate, it is important to remove the effect of the financial risk (gearing) from each of the proxy equity betas so as to get the asset betas which reflect the business risk alone. The debt beta is considered zero due to the assumption that the debt beta is usually very small when compared with equity beta and the tax efficiency of debt that further reduces the weighting of the debt beta leaving asset beta. Since this procedure removes the effect of the financial risk or gearing of the proxy company from the proxy beta it is always referred to as ungearing the equity beta.

Averaging asset betas

Ungearing equity beta of proxy companies it is observed that the resulting asset beta value will be slightly different values. This is because two proxy companies cannot have the same business risk. In order to remove the effect of the slight differences in business operations and business risk that are reflected in the asset betas, we average the betas.

Regearing the asset beta

This can be done by using the ungearing formula and inserting the gearing and the tax rate of the investing company and the average asset beta, and leaving the equity beta as the only unknown variable.

Bloomberg adjusted beta

The Bloomberg adjusted beta is defining an estimate of a security’s future beta which is derived from the historical data but is modified by the assumption that a security’s true beta will move towards the market average over time. Stock betas can be presented as either an adjusted beta or as a raw beta. A raw beta also known historical beta is the observed relationship between the security’s return and the returns on an index. The adjusted beta is an estimate of a security’s future beta. Adjusted beta initially derived from historical data but modified by assumption that a security’s true beta will move toward the market average of 1 over time. Adjusted beta has higher correlation than calculated beta and lower correlation than beta equals 1.

For an investor to invest in stocks it is important to understand how risky the stock is in the market. Beta determines how risky the stock is in the market and gives the market risk of other stocks where comparism can be made easily. The standard value 1 of beta acts as a reference point for the investors to decide whether to invest in a portfolio or not. The beta value that is more than 1 means the stock price is moving in the same direction as the market. Beta relates to the market in various ways, a negative beta (gold and gold stock) this can be explained that the stock does better only when the stock market moves down. Furthermore when beta is zero and there is no inflation, the money value is the same (unchanged). Beta between 0 and 1 indicates that the risk is below the market (Most utility companies fall within this range). When beta is more than 1, the risk is greater than the whole market. Being aware of the various risk associated with stock market, investors can choose on what stock to invest in. Some investors prefer stock with less risk while others prefer those with higher risk. However investors now understand and are able to make decision on which investment will match the risk they are comfortable with.

Investors should note that beta values for stock volatility in 2009 should not be used to predict or forecast the beta for 2010 because of its instability. Another point of concern is that beta only measures systematic risk, i.e. the risk the whole market is facing but not the risk the company is facing.

To determine Henkel corporate beta using the Excel as shown in the table at last page, it show that the corporate beta for Henkel is 0.64 this value is less than 1 indicating that the risk is less than the market. If we consider the unlevered beta across the companies doing the same business with Henkel and compare, it is observed that Henkel is doing better than other company like Oriflame with a beta of 1.24 indicating that its risk is greater than the market as a whole. If we also compare companies that are using the same currency as Henkel, we still can conclude that Henkel is performing well. Taking a critical look at the beta values, the beta value of Henkel is the same as the average beta this indicate how better Henkel is performing.

In conclusion is worth noting that the company performance is influence by the currency and the market situation at that time. However if all these companies are subjected to just one currency in the same market situation the result will differ.

Henkel Financial issues

Cost of debt

The cost of debt according to the financial times definition is actual rate companies pays on currents loans, bonds and other form of debt. Almost all firms use debt to finance their business operations despite the cost charged for each type of debt. Most firms will want to borrow low since there is no risk to debt as bondholders have enough asset cover. Terek S. Z. (2010) argued that a company without debt mean that company is able to grow and add more business that will generate surplus cash. When borrowing rises, the risk increases proportionately on bondholders in paying debt interest and the asset cover. Terek S.Z. (2010) further claim that high debt level may restrict firm’s ability to payment of dividend since more cash shall be required to pay debt.

Traditional view (trade off theory)

Robert S. & Steve J. (2011) argued that the trade-off theory provides an explanation of the benefit of cautious use of debt and the dangers of excessive use of debt. This theory makes use of both the substitution and financial risk effects to give an explanation of how debt and cost of equity relates. Robert S. & Steve J.( 2011) summarises this view in two ways, first they claim that interest expense is tax deductible therefore as firm uses more debt the more they create wealth through lower tax payment (tax shield).But as firm add more and more debt, the tax payment become large adding value to the firm to the point where it begin to be financially distress by trying to meet interest payment obligations. Secondly, they went further by saying that as firm begins to add debt to its capital structure, WACC falls because the firm is using cheaper form of financing however the WACC will start to rise as creditors and shareholders begin requiring ever-increasing return as risk rises Robert S. & Steve J. (2011). Hence the traditional trade off theory results in a level of borrowing that is aimed at minimising WACC and Maximising the company value. Sisira R.N.C. (2007) argued that, the static trade-off theory of capital structure emphasises the balance between the tax shield benefits resulting from interest payment and the bankruptcy cost of debt. This trade-off theory was developed by Modigliani and miller to illustrate that debt is use full because interest is tax deductible and that debt brings with it cost associated with actual bankruptcy,QA23W argued by Eugene F. Brigham (1994).

Modigliani And Miller Theory (M&M)

The M&M proposition 1 suggest that the value of the firm will be the same irrespective of its capital structure because changes in capital structure will not change the total value of the claims that debt holders and shareholders have on cash flow. M&M went forward to suggest another model, M&M proposition 11 where they introduced tax to find the impact. They suggested that, the use of debt in a firm involves both benefit and cost. At very low level of debt the benefit is more than the cost and when there is an increased use of debt the WACC of the firm reduces. Sisira R.N.C. (2007) argued that tax issues and interest rates are theoretically important not only in determining the amount of the debt, but also in terms of broader financing decision. At some point, as the amount of debt in a firm increases the cost outweigh the benefit. But when the cost equals benefit the WACC is minimised. In summary the most important benefit of including debt in a firm is that firm can deduct interest payment for tax. Hence firm value can increased by leverage since interest payments are tax deductible.

Bond Rates.

The credit rating agencies like the standard and poor (S&P), Moody’s, and the Fitch assign rating to bonds. This rating reflects their chances of being default. Martin O’Donovan (2004) argued that, the ratings of company may affect the capital requirements of the bank’s lending to that company and in extreme cases a downgrade can be the final trigger that puts a borrower into default. The highest grade bond Aaa or ( AAA) are those with least default risk. The risk premium on bonds will increase if the rating becomes lower. Bonds rated from A grade to triple B grade (A to BBB) are strong enough and are called investment grade while those rates below BBB are non-investment grade and they have the highest risk of default. Down-grading a firm bond affect its ability to borrow long-term capital. Martin O’Donovan (2004) claim that credit rating agencies play an important role in the efficient operation of global capital markets since investors and lenders rely on the credit rating agencies to provide an opinion of the creditworthiness of debt issuers and borrowers. Yongtae K. (2003) also argued that bond downgrades are associated with significant declines in the stock prices of the affected firms.

Maturity Date

The date at which the bond expires or matures is known as the maturity date. It is noted that bonds have different maturity period which might be classed as short term or long term maturity period. The duration of the bond is determine by its date of maturity either is less than 5 years for short term bonds or above for long term bonds. But as year pass by, the maturity declines. Some bonds have provision which allows the issuer to pay them off prior to maturity date. Leonard Tchuindjo (2008), claim that as a result of a decline in credit quality of an issuer or an expectation of a major change in business condition (such as an interest rate change by central bank), the yield to maturity of a bond can increase consistently from one day to another.

For Henkel, the maturity period that is most appropriate to valuing the company is 10 years and the bond rate is 4. The explanation is that Henkel is rated A- by the rating agency standard and poor (S&P) but this rating is found in the European rating system therefore the rating is got by a careful interpolation between reported portfolios in the European rating system. An interpolation between nearest rating within the European rating system gives the correspond value of 4……. that fall under a 10 years maturity period. Henkel A- rating indicate that is has a lowest default risk and classified under investment grade.

Recent reporting from Henkel’s website shows that the rating has moved from A- to A showing an improvement and a likely wood that most investor and firm will want to do business with Henkel. These also indicate that Henkel has gain trustworthiness from lenders which it can use to borrow or buy more bonds to expand its business. It is important to note that a 10 years German Eurobond is preferred when one is to value a European company since German bonds have higher liquidity and lower credit risk than those of the rest of European countries.