Assessment of the Capital Asset Pricing Model and Capital Budgeting Analysis

Question

Part – A - CAPM

“A Critical Assessment of The Capital Asset Pricing Model (CAPM)”

You are required to

  • Describe the Capital Asset Pricing Model, including the assumptions underlying the theory
  • Explain the relationship between the Security Market Line and the Capital Market Line, using diagrams and examples to illustrate your explanation
  • Briefly set out arguments in favour of – and against - the theory, outline its uses and make a critique of its underlying assumptions.
  • Identify any alternatives which have been suggested in place of CAPM
  • Conclude with an overall assessment of the theory and state any recommendations which emerge for financial managers and investors, and summarise your overall conclusions. Your critique will be assessed.

Part – B – Capital Budgeting Analysis

You are required to work the following problem, using a discounted cash flow (NPV) analysis.

“Henry Hall is considering replacing an old machine with a new one. The old machine (purchased 5 years ago) cost $300,000, while the proposed new one will cost $250,000.

“The new machine will be depreciated prime cost to $50,000 over its 5 year life. Henry estimates that it will be worth $40,000 (salvage value) after 5 years. The old machine is being depreciated at prime cost to zero over its original expected life of 10 years. However, Henry can sell the old machine today for $78,000.

“The new machine will save the owner $50,000 a year in cooling costs. This was estimated one year ago in a feasibility study on the new machine conducted for Henry by an external firm of consultants, and which cost Henry $15,000. Henry still considers that these savings will be achieved.

“With the new machine, a one-off amount of cleaning supplies at a cost of $5,000 will be required. and Henry estimates that accounts receivable will increase by $15,000. Both of these increases in working capital will be recouped at the end of the new machine’s life in five years time.

“Henry’s cost of capital is 10%. The tax rate is 30%. Tax is paid in the year in which earnings are received.

  • Calculate the net present value of the proposed change, that is, the net benefit or net loss in present value terms of the proposed changeover.
  • Should Henry purchase the new machine? State clearly why.”

Summary

This question belongs to financial management and discusses about capital asset pricing model and capital budgeting analysis.

Total word count: 886

 

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