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(^70) Financial Management
On the other hand, Security Y with a beta of around 1.7 requires a rate of return of
around 16% but its expected return is only about 7%. This tells us that the asset is
overvalued or overpriced and hence unattractive because it is expected to produce a
return lower than stocks with similar betas. These two assets should move toward their
equilibrium - required return positions on the SML (i.e., expected rate of return should
be equal to required rate of return and correspond to their respective betas).
To reach equilibrium and their required rate of return positions on the SML both stocks
have to go through a temporary price adjustment. In order to reach equilibrium, assuming
betas remain the same, the expected return of X has to be brought down to be equal to
the required rate of return and be plotted on the SML. To accomplish this, the purchase
price has to be sufficiently increased. Similarly, for security Y, the purchase price has to
be sufficiently reduced so that the expected return rises to be the same level as the
required rate of return.
In practice, investors will be interested in purchasing security X because it offers more
than proportionate returns in comparison to the risk. This demand will push up the price
of X as more of it is purchased and correspondingly bring down the returns. This
process will continue till it reaches the equilibrium price and the expected returns are
the same as the required returns.
In the case of security Y, investors will be tempted to sell as it offers less than the
required rate of return. This increase in the supply of Y will drive down its price and
correspondingly increase the return until the expected return rises enough to reach the
SML and the security is once again in equilibrium.
Thus, the CAPM provides many useful insights for the finance manager to maximise
the value of the firm. It shows the type of risk for which shareholders require
compensation in the form of higher risk premium, and hence higher returns. Because
finance managers also perform the investment function on behalf of shareholders, they
must keep sight of the returns shareholders expect for taking risks.
Now let us look at another part of the investment decision, i.e., what cash flows to
include and what cash flows to exclude.
Cash Flow
In considering investment decisions, it does not matter whether outlays are
termed 'capital' or 'revenue' nor whether inflows are turned 'profit', 'depreciation', 'tax
allowance', or whatever. All outlays and income must be taken into account.
Cash flows in this context is not the same as the cash flow through a bank account, nor
is it identical to accounting profit, since changes in the later can occur without any
change taking place in the cash flow.