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The Capital Asset Pricing model

The Beta of a share measures the expected return for a share in relation to the expected return for the market as a whole. Thus the higher the Beta the greater is the expected return from a particular share when compared to other shares. Consequently the higher the Beta the higher is the cost of share capital for a company because of the greater expected returns and the lower level of risk.

Betas are calculated by a number of organisations. Datastream is one such organisation which derives a beta factor by performing a "least squares" regression between weekly adjusted prices of the stock and the corresponding Datastream market index for a five year period. Typical values are around 1.00 and might range from 0.7 to 1.3 although higher or lower figures are not unknown.

The cost of capital for a business

Although this would appear to be a relatively simple calculation, the reality for a business is more complex than this. We have seen that Beta measures the level of risk for a share but that this is based upon an average of past performance, and Beta will tend to change over time. Moreover past performance is no predictor of future performance, whereas investment appraisal is based upon a prediction of future performance.

Thus knowing the Beta for your company at the present will provide an indication of past performance but will not enable an accurate calculation of the cost of capital to be used in the future. This is particularly the case when a proposed investment is based upon factors which are quite different to the past.

Thus, for example, an exercise leading to increased diversification could well be much more risky than current operations (because of such things as lack of experience or uncertainty about future demand) and this may well need to be evaluated using a very different cost of capital in the appraisal. The CAPM provides no basis for calculating such a cost of capital, and managerial judgment is required in this instance to derive an appropriate discount factor.

Most large companies are not composite businesses but consist of a number of different business units. These different units may well be engaged in very different activities for which different rates of return (in terms of either net profit percentage and / or ROCE (return on capital employed)) could be expected. If these business units were separate entities then they would be expected to have different Beta values and different costs of capital.

In such a circumstance a company wide cost of capital is not appropriate, and therefore different costs of capital for each of the business units should be used. However as they are not different entities no such Beta values exist and in this case also the CAPM provides no basis for calculating such a cost of capital and managerial judgment is required in this instance to derive an appropriate discount factor. This argument can also be extended to a consideration of different investment alternatives in a single business unit. If different levels of risk are associated with the different alternatives then the reality is that different discount rates should be used for the different alternatives.

Summary

It is clear that the definition of corporate governance has extended considerably beyond investor relations and encompasses relations with all stakeholders - including the environment. This is essential for the longer term survival of a firm and is therefore a key component of sustainability. There is evidence that some firms understand this but they are in a minority. So it is possible to say that good corporate governance will address this but that not all firms recognise this.

Similarly the amount of disclosure regarding all activities has been increasing rapidly over the last decade, as firms have recognised the commercial benefits of increased transparency. Therefore it is reasonable to argue - as we are doing - that the amount of information regarding the relationship between governance and social responsibility will also increase, not just as firms gain a clearer understanding of that relationship but also as they understand the benefits of greater disclosure in this respect. Thus we consider that this will become more apparent over time.

The most important point to note however is the relationship between corporate governance and the level of risk to which a firm is exposed. Good governance reduces the exposure of a firm to a whole variety of risks. This is clearly recognised by investors and potential investors and so the cost of capital is lower if a firm has good procedures for its governance.

References

Davila Gomez A M & Crowther D (2007); Ethics, Psyche and Social Responsibility; Aldershot; Ashgate

 
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