MBA 3rd year (BFI) Programme

Date

English Department Translation by

DLER GHAFOUR RAHEEM Member Name

17223MBAF Member Number

Section A:

Questio Answer
n
1 1
2 4
3 2
4 4
5 1

Section B: (i)

CAPM: This reflects the relation between the return and risk through using the beta (β) coefficient as
the measure of risk. In this model, the required rate of return on risky investment is determined through
adding the risk premium to the risk-free rate of return.

ri = rf + bi (rm – rf)

CAPM:

Required rate of return on share: ri

Risk-free rate of return: rf

Beta coefficient of the share: bi

Rate of return on market portfolio: rm

Risk premium which means the required rate of return plus the risk-free rate of return: bi (rm – rf)

Market risk premium: (rm – rf).

a- Outflow: This means the cash outflows used in the project, as the income resultant from the
operating processes is considered cash inflow and it is the difference between the revenues
(inflows) and expenses (outflows). Hence, the interest is calculated within the expenses which
are outflows.
 b- Inflation: This affects the value of money, as when the inflation is high; the currency declines so
that the concept of NPV is affected by inflation considerably.

Security market line (SML):

This represents the linear relationship between the required rate of return on security and the degree of
systematic risk measured by the beta coefficient. As at a specific level of systematic risk, the security
market line reveals the required rate of return. Moreover, the slope of the security market line expresses
the market risk premium (rm – rf) when it is stable.

CAPM:

The SML defines the risk taken to reach the efficient portfolios, but it is important to recognize the
relation between the expected return and individuals' risking the securities. Actually, the only
coefficient which can reveal the expected return on the single security is the extension of the expected
return on a specific security different from the expected return on the market portfolios. In fact, this
relation contributes to determine the definite, systematic risk which can be avoided in an easy and
simple way. Furthermore, the CAPM refers to the possibility of displaying the expectations of returns
under the difference between a specific security and the market portfolios. On the other hand, the
systematic risk – which the investor is compelled to face – is related to the different transactions
affecting the different securities.

- Beta coefficient (β) as a measure of risk:

The CAPM helps in determining the security price in the capital market in case of not expecting the
return from facing the definite risk. Basically, under the beta coefficient, it is easy to guarantee a high
return on portfolio but in the normal degree of risk. Capital Asset Pricing Model is one of the routines
used for decision making for investments. Simply stated, this model measures the expected return of a
security and its risk. It has the following equation:

Expected Return = Risk free rate + β (market expected return – Risk free rate)

- The expected return is the return expected on the security.

- The risk free rate is sometimes taken to be a 10-year (or more) government bond.
- β is a measure of the volatility of the stock under consideration
-

β is a measure of risk or volatility. Many take the default value of β to be 1.00; so if a company has a β
of 3, this means that the company is 3 times as risky as the total market. For example, assume that an oil
company has a risk free rate of 4% and its β at 3 and the market’s expected return is 12%, the Expected
Return of the company would then be:

ER = 4% + 3 (12-4) = 4+24 = 28%

So, this stock is expected to return 28%.

It’s important to note that changing the value of β would change the expected return on the investment
significantly. Assume that for that oil company the value of β was 1.5, then the expected return would
drop to 16% (4+1.5(8)).

Section B: (ii)

It is important also to understand that the model is based on certain assumption of which some are:

1. Taxes and other expenses aren’t considered here.

2. Investors understand the market in the same way.
3. Most investors hate risks and try to avoid them.
Other assumptions to be considered when developing the CAPM:

1) There are no definite investors controlling the capital market.

2) The investors prefer the expected return on security and its variance.
3) All the investors understand the securities similarly.
4) There are no costs of transactions.

The CAPM requires the investors protection which includes the following aspects:

a) The investors should run diverse projects in order to get rid of most of the definite risks of their
portfolio.
b) The Investors should reveal whether they prefer the investment under the maximum risk (β ≥ 1),
medium risk (β ≈ 1) or low risk (β ≤ 1) of securities.
c) The financial managers' conclusion of the discount rate related to the real investment projects is
variable.
d) The work value is the total NPV related to the current projects; subsequently, the new projects
which have positive NPV maximize the work value.
e) According to the researches of the capital efficiency, the economic significance related to work
reflects the price of share; therefore, the projects with the positive NPV can increase the value of
security market. On the other hand, the CAPM clarifies the expected return which accords with
the individuals' investment.
Consequently, it can be said that the capital market works on marketing the goods under the risk and
expected return, as the price of the individuals' real investments is determined according to the price
risk. In fact, this method is an essential and rational one under considering the maximization of the
shareholders' wealth as the main objective of work. Actually, it is difficult to estimate the cash flow
unless the difference in the security market is appreciated.

 The CAPM is used in getting a discount of the real investments (practical problems). Indeed, the
following factors should be estimated with the aim of getting a suitable discount rate through the
standards of the CAPM:
1) Measure of risk (β): it is the lowest problem-maker factor where it is calculated over five years
and it can predict the beta related to the same portfolio over the next five years.
2) Risk-free rate (RF): this helps in knowing the assets which do not involve risk in addition to
estimating its potential value in the future.
3) The expected return on the market portfolio: this factor may change over years and thus it is
difficult to be predicted precisely. Moreover, the average return related to the past periods can be
used as an alternative to the future predictions.
 Tax and CAPM: the tax rates related to the companies should be predicted and discounted from the
capital and hence a question arises; is the CAPM used in obtaining the discount rate before or after
tax? Of course, the answer is after tax because the expected returns on the market portfolio – which
can be used in the CAPM – are calculated after tax.

Section C:

The methods of investment appraisal:

First, the net present value:

As the investors are compelled to spend money in different periods of time and there is financial return
in different periods of time too so that the value of money should be assessed at the present time. For
example, if the usual return of the bank is (10%) so that the 1100 pounds gained after one year is equal
to the 1000 pounds at present. In other words, the 1000 pounds is the present value of the 1100 pounds
after one year in the bank.

Second, the payback period:

This technique answers the following question: what is the period after which the invested money can
be paid back? For example, supposing that a project is started and its cost is SR 9000, and the expected
return (cash flow) during the first year is SR 4000 and during the second year is SR 5000. This means
that the capital is repaid after two years which is the payback period. Actually, PBP is easy to be used
and understood so that it is a good method for taking the simple investment decisions. Over and above,
the PBP is used in the large organizations in order to assess the small projects such as establishing a
small inventory or buying photocopiers and so on.

Besides, studying the PBP is a significant method to the projects with a short life span or those which
are threatened by the appearance of alternatives in a short time. Subsequently, it is important to ensure
repaying the capital in a short time. On the other hand, the disadvantages of this method are as follows:

- This method ignores the time value of money changes, as it considers that the future value equals the
present value. According to the previous example, the capital is paid back after two years but it is
worth noting that the present value of profits is lower than its value before two years.
- This method neglects the value of cash flows after the payback period as the PBP may be long but
the project is profitable on the long run. In addition, when comparing two projects, the lower
profitable project on the long run may have payback period shorter than the other project.
- This method is considered an optional process and such matter may lead to excluding good projects.

Third, the internal rate of return:

It is easy to express the success of a project through estimating its rate of return but the IRR means
calculating the interest rate which gives a present value equal to zero of all the cash flows. For example,
if there is a small project with 1000 pounds cost and it gets 1200 pounds after one year, its IRR will be
20%. In fact, this method is easier than the NPV because any manager or investor can understand the
meaning of the internal rate of return. Moreover, in case of studying two projects or more, this method
avoids the problem of the conflict between the results of the IRR and the NPV; which exists in the PBP
technique, through neglecting the value of the IRR and uses the NPV only. One of the reasons of this
conflict is that the IRR neglects the size of return, but the NPV compares it to the total value added to
the wealth of investors. In exceptional circumstances, there may be many IRRs or there is no IRR at all;
such matter occurs when the cash flow changes from positive into negative repeatedly.

Fourth, the profitability index:

The profitability index depends on calculating the present value of the cash flows but instead of
calculating the NPV, it calculates the ratio of the cash flows during the life of the project excluding the
initial cost divided by the initial cost of investment.

PI = present value of cash flows / initial investment

If the PI equals one (1), this means that the project gains one pound in return for each pound invested
and thus the project will be accepted. Besides, if the PI is higher than one, the project will be accepted
too, as the more the PI value increases, the more the project is preferred from the financial aspect. On
the other hand, if the PI is lower than one, the project will be rejected.

Although there are defects in the four methods, it cannot be neglected that each method has its
advantages so that the investor can use two methods at the same time such as the PBP and NPV, etc.

Section D:

NPV: if the investment is commercial which aims at maximizing the wealth of the investor, the NPV
criterion will be the most suitable amongst the four methods.

In this case, the machine (B) is selected according to the NPV criterion because of the following
reasons:

 NPV of machine (A):

Year 1 = 40 / (1+0.1) = 36.36

Year 2 = 40 / (1+0.1) 2 = 33.06

Year 3 = 40 / (1+0.1) 3 = 30.05

Year 4 = 20 / (1+0.1) 4 = 13.66

Year 5 = 20 / (1+0.1) 5 = 12.42

Total = 125.55

Net present value of machine (A) = 125.55 – 120 = 5.55

 NPV of machine (B):

Year 1 = 20 / (1+0.1) = 18.18

Year 2 = 30 / (1+0.1) 2 = 24.79

Year 3 = 50 / (1+0.1) 3 = 37.57

Year 4 = 70 / (1+0.1) 4 = 47.81

Year 5 = 20 / (1+0.1) 5 = 12.42

Total = 140.77

Net present value of machine (B) = 140.77 – 120 = 20.77

Based on the NPV of the machine (A) which is 5.55 and the NPV of the machine (B) which is 20.77, it
is clear that the NPV of the machine (B) is the highest so that it is selected.

- Internal rate of return:

IRR = cost of investment / net cash flow for five years

IRR of machine (A) = 120000 / 20000 = 6

IRR of machine (B) = 120000 / 30000 = 4

The IRR of the machine (A) is higher than the IRR of the machine (B) so that machine (A) is selected.

- Payback period:

PBP = value of initial investment / average expected annual cash flows

 PBP of machine (A):

Cash flows of this machine = 40 + 40 + 40 + 20 + 20 = 160

Average cash flows of it = 160 / 5 = 32

PBP of it = 120 / 32 = 3.75

 PBP of machine (B):

Cash flows of this machine = 20 + 30 + 50 + 70 + 20 = 190

Average cash flows of it = 190 / 5 = 38

PBP of it = 120 / 38 = 3.16

The PBP of the machine (B) is shorter than the PBP of the machine (A) so that the machine (B) is
selected.