Capital Asset Pricing And Discounted Price Flow Models

Capital Asset Pricing and Discounted Price Flow Models

Knowing the risk of an investment and understanding how that risk will affect any

future returns are crucial aspects in deciding if the expected return is worth the risk. The Capital Asset Pricing Model (CAPM) provides a base from which both the risk and the affects of the risk are determined by the investor while the Discounted Price Flow Model (DPCM) can help the investor decide what amount they are willing to invest in a company in anticipation of projected future cash flows.

As indicated in the previous paragraph, the Capital Asset Pricing Model is a tool used in determining the risk of an investment and in turn, deciding if the risk is worth the investment. The CAPM generally fosters the idea that not every risk is considered in determining the value of an asset; in fact, by diversification, some of the risk can be eliminated. The CAPM starts with the idea there are two primary risks involved in investments: Systematic and unsystematic.

Systematic risks are those risks, such as interest rates, that cannot be eliminated through diversification. Unsystematic risks are those risks that are inherent to specific types of stocks. As the individual investor builds his portfolio, the risks decrease. Because systemic risks are the risks that cause the most anxiety for investors and as a way to calculate those systemic risks, William Sharpe created CAPM.

With the recent spate of financial scandals, the Discounted Price Flow Model has taken on a new importance. The DPFM is used to determine a company's value based on its projected future cash flows. Forecasted free cash flows are discounted to a present value using the company's weighted average costs of capital. (Investopedia) By developing a DPFM, the investor will get a good view of the company's earning growth, balance sheet capital structure and expected growth duration among other indicators of a company's efficacy.

The DPFM gives a bona fide stock value because it does weigh all of the inputs unlike other avenues such as P/E's and price-to-sales ratios in which stocks are compared to one another rather than judged on intrinsic values. (Investopedia)

Debt Equity Mix

The cost of debt is equivalent to the interest rate a corporation, and individual, or a household is paying on all of its debt such as loans or bonds. Debt is inclusive of repayment later, just as savings can be used later. It is believed that corporations with higher debt are frequently the riskier conglomerates. The risky behavior of some businesses can sometimes be attractive to potential investors, while causing others to shy away. Household debt unfolds similarly to that of major corporations, but on a smaller scale. While the bulk of credit in a household is extended in the form of mortgages, a lot dwells in the plastic credit cards. Unfortunately, credit is often used to bridge the gap in income or temporary drops and can ultimately cause the debt of a household to increase substantially. Credit cards often enable some households the consumption of possibilities that would not otherwise be around.

The characteristics of debt or one's income path help determine the growth of the market, increased interest rates, and timing. Debt differs from assets in many ways because it is in nominal terms and has to be repaid. Unlike assets such as a luxury car or a spacious mansion, debt usually does not carry negative connotations. An extravagant home may carry such connotations depending on the neighbor's suspiciousness. Assets can be bequeathed and that is unlikely in any scenario regarding debt. For example, the father in a family perishes and the children inherit the family business as it relates to assets. Debt would only be passed down to those contractually obligated or legally liable. In addition, in order for one to enter into debt he or she must find a lender who is willing to lend at acceptable conditions to the borrower.

The cost