Appendix 5 - Mergers and Acquisition's, is it all beneficial for the acquiring company?

In my previous blog entry titled 'Methods of valuing companies' I discussed 3 methods a company may use to value shares and the companies as a whole. It is important to get the value of the target company for takeover correct as the target company will refuse the bid if undervalued. In this blog entry we will concentrate on the benefits and drawbacks of mergers and acquisition.

Reasons for merger and acquisition
Looking to acquire another company the acquiring company may see such advantages as increase efficiency and value. Efficiency can be improved as assets can be shared across the companies to fully utilize the available assets. Value can be increased as acquiring a new company can strengthen the company's brand along with purchasing power. Another advantage is Synergy that is the magic power that allow for increased value efficiency of the new entity and it takes the shape of returns enrichment and cost savings.If in the same industry economies of scale can be used to purchase assets but from bulking buying can look to reduce the unit costs. The acquiring company may recognize that the target company is poorly managed and so from a takeover a new management team can be implemented to hopefully achieve better success fort hat company. The biggest advantage is tax benefits. Financial advantages might instigate mergers and corporations will fully build use of tax- shields, increase monetary leverage and utilize alternative tax benefits (Hayn, 1989). Accounting studies show that the acquisition of a company does not always create value and sometimes can lose value.

Reasons against merger and acquisition

Company will face major difficulties thanks to frictions and internal competition that may occur among the staff of the united companies. There is conjointly risk of getting surplus employees in some departments. Many people may lose jobs and require redundancy packages which are costly and can give negative company image.A consumer will see a disadvantage in that less choice of businesses for consumers. Another disadvantage may be conflict of objectives between both companies. Acquisition is a very expensive long planning process and will often lead to increased debt for the acquiring company to fund the deal. 

Different types of mergers

Horizontal mergers are between firms in the same industry, Vertical mergers are combinations between firms at different stages and conglomerate mergers are firms in unrelated business activities. Horizontal mergers is less risk taking than the others as the acquiring company will have knowledge of the market and will have assets which can be shared between the companies to strengthen market performance.

Different takeover strategies

Friendly takeover is when the target company board of directors supports a merger, negotiates with potential acquirers and agrees on the price that is ultimately agreed by shareholders after vote. Hostile takeover is where an individual or acquiring company purchases a very large amount of the target company's stock and in doing so will get enough votes to overpower the board of directors and CEO. Friendly takeover is often seen as the best choice for both companies to agree value and terms while coming off as ethical in the media spotlight giving both companies positive image. Hostile takeover often seen as desperate measures a company will go and normally a last choice by companies.

Slowdown in M&A activity

Due to the recent recession market confidence fell reducing corporate activity. Some companies were unable to fund possible mergers and acquisitions due to bank's not lending. Many companies just refocused on their core business areas instead of diversifying through M&A activity. Market confidence has however has improved over the last year and people have regained confidence in the banking industry.

Conclusion

From the above points and displayed information, Merger's and acquisition is not all beneficial for the acquiring company due to friction and internal competition causing difficulties among workforce. Also much of the workforce may lose their jobs giving the acquiring company a negative public image and also increased debt to fund the acquisition. Accounting studies show that the acquisition of a company does not always create value and sometimes can lose value which would go against a business target of maximising shareholder wealth. Planning process to takeover a company is a long process as there is high amounts of risk involved, Shareholders may need to ask themselves the following questions when looking to acquire another company to improve shareholder wealth"Is it worth it considering the high amounts of risk involved?" and "How long will it be until we see the benefits?".

Appendix 7 - Importance of implementing the correct dividend policy to help satisfy shareholder demands

Dividend policies are crucial to a company and helps with the relationship between the shareholders and investors. Dividends are the sum of money paid to the company's shareholders out of the company's profits to reward them for their investment in the company. A company must decide on a policy which states the value they will pay out to the company's shareholders in dividends. A company spend a huge amount of time deciding on the dividends policies to help satisfy the needs of the shareholders; Setting a low dividend policy can lose investor confidence and setting a high dividend policy means it is unsustainable in the long term and the business may not be able to year on year make the high dividend payments to shareholders due to fluctuations in the market and not been able to predict certain future business events. The company needs to aim for stable dividends with stable growth.

Once the company has agreed a dividend policy and have implemented it into the business if profits are down over the year, then normally managers will still pay the agreed dividend policy. Managers will do this to send a signal to shareholders that the fall in earnings is only temporary and will be resolved soon, it also helps to maintain the company's share price. If profits are very high over the year, directors will become very cautious to payout high dividends due to uncertainty of been able maintain this high level of dividend payout in the future. Therefore company's may adopt a conservative approach, due to uncertainty over the future. Thus, set dividends at a low enough rate to ensure the company can always maintain future dividend payments, whilst maintain enough to satisfy future investment requirements and in the long term avoid shareholders from missing out on the high returns.

Constant Growth Dividend
This policy is favored by shareholders as it is agreed of growth year after year which will boost the returns for the company's shareholders. The company may have issues if they promise too much of the company's ability for growth to the shareholders. A company must know what they can deliver and keep the shareholders happy. Problems will quickly arise if a company's earnings have fallen and do not meet the level the company expected and thus cause issues with paying the increasing dividends. With the failure of success in the company's own dividend policy this will cause financial problems as the company pays out dividends which they cannot afford but satisfy the agreed arrangements in the policy. Also shareholders will lose confidence in the company as they notice the issues of paying out increasing rate of dividends, and will question the future returns of dividends. If the company is able to pay the shareholders the increasing dividends then this will benefit shareholder satisfaction along with delivering good returns and helping to maximise shareholder wealth.

Constant Payout Dividend
This policy agrees on the set amount to be paid to shareholders each year without the company having to promise growth. This policy can keep shareholders happy with payouts on shareholders investments as the shareholders will no the set amount they can expect to receive. Advantages for the company is that it is less pressured to keep growing revenue and will not put huge amounts of strain on the company's cash flows if profits are currently lower than expected. 

Experian dividend payment method
Experian the global information service company in 2014 paid 37.50 cents per share, it is a constant dividend payment made to the shareholders with the promise that they are able to deliver every year a return to shareholders. Any increase in dividend payment from the previous year is due to high growth of return that the company has seen and therefore split the increased return between shares. The company however remains with a constant dividend payment as the information services industry is facing increasing risks in the future and are struggling to anticipate future growth rates and therefore uncertain if the company can pay any rises in the dividend policy if the company chose to opt for the constant growth dividend policy.  Experian  is one of few companies in the information services industry that actually pay dividend payments but this is due to the company been market leader and have an objective of to make returns to the company's shareholders.


Consequences of changing a policy
A policy once agreed and implemented in the business should remain consistent without changes to the policy to keep shareholders happy as it creates certainty of the amounts of payouts the shareholder will receive for their investments, also not changing the policy will help attract new investors and build up their confidence on what to expect thus improving the possibilities of investments for the future of the company. Changing a policy can create tension and uncertainty among a business, if the company has a constant growth dividend policy thus increase in dividends every year but the company is unable to fulfill the growth then changing the policy to what the company is actually able to achieve with the payments of dividends this will create negativity between the business and shareholders. Changing the policy means shareholders needs no longer fulfilled and this may cause them to see shares in the company and seek shares from elsewhere that does meet the shareholders needs. The only time that shareholders will want to see a change in policy is if the dividend payout rate is too low and not in line with the earnings of the business therefore greater amounts of dividends can actually be paid to shareholders. Changing the policy for this reason making the payout of dividends higher to reflect earnings of the business will help to generate higher returns for shareholders and help maximise shareholder wealth. Some companies do not make dividend payments every year such as Amazon due to the financial crisis and some companies with agreement from shareholders would see money spent in investment instead with the hope of returning bigger financial gains to shareholders in the future.

Conclusion
Overall the company must put in place the correct dividend policy which takes into account shareholders demands and capabilities of future growth in revenue/profit. The policy should not change so shareholders know what to expect. Planning of the policy is crucial before the policy is implemented in the company. A dividend policy is very important to keep shareholders happy and stop shareholders from selling shares and going elsewhere to invest.

Appendix 4 - Which methods of valuing companies is best to ensure correct value is obtained?

Companies must understand what creates value before they put in a takeover bid to acquire another company. The offer value must be agreed between both companies and therefore have a alignment on the value of the soon to be acquired company's value. Shareholders wealth of the company to be sold will have been maximized due to the selling of the company and the shareholders of the company placing the bid will have expanded the companies portfolio and with the hope of seeing long term wealth gains.

A company could have maybe looked at the following three methods basic valuation methods to value the target company which they hope to acquire; Stock market valuation, net asset value based valuations and income based valuations.

Stock market valuation

Stock market valuation is the number of ordinary shares issued multiplied by market price. Market value is correct if efficient market hypothesis applies. The value is semi-strong based off past and present information. However manager could have new information such as new innovative products which would increase the value of the company. This method is useful as it gives an idea to the purchasing company to the purchase price.

There are issues with this valuation method such as it quotes share price and does not give true reflection on the value of all the shares as only a small proportion of shares are traded on a day to day basis so this method does not reflect all of the corporate value. If the company’s shares are not quoted or on a stock exchange this valuation method is impossible. This method will give the buyer a possible share purchase price but will not help with to working out the company’s value (worth). This method also requires a substantial premium to get shareholders to give up  their shares because of the above issues. Also when news breaks of a possible takeover bid, shareholders will be more reluctant to hold onto their shares and the buying company will have to pay higher prices for the shares to obtain them.

Net Asset Valuation

Also known as book value, can be worked out by fixed assets plus net current assets minus long term assets to give you the company’s net asset value. This method uses historical costs which are both factual and available then trends can be drawn up from previous year’s data. This method is not accurate as the buyer will not understand if the depreciation method was the right choice at the time and may have issues with the chosen method. The method ignores intangible assets such as brand names and patents.  Highly skilled work force is another intangible asset, if this work force left this would devalue the company as this would account for loss of assets but this method does not include these intangible assets. This method also does not detail any future wealth generation ability such as any new products been released to market. This method can be useful in liquidation.

Income based Valuations

Looks towards the future income of a company.

Issues with this method are that it is unreliable and inaccurate to predict value growth rates on past growth. Too reliant on predictions and assumptions. Quality of data very poor normally just estimates.Gordon's dividend growth model is an example of income based valuations as is price earnings ratio model and discounted cash flow valuation.

Income based Valuations - Gordon's dividend model

Gordon's dividend growth model determines the intrinsic value of stock, based on future series of dividends that have a constant rate of growth. Provided that the dividend per share is payable in a year, the assumption of the growth of dividend at a constant rate is eternity, the model helps in solving the present value of the infinite series of all future dividends. Since the assumption is based on the constant growth rate of dividends, this formula would be applicable mostly to well established and mature companies. This model was developed by Professor Myron Gordon, hence called Gordon Growth Model.
Formula:

Where: 
D = Expected dividend per share one year from now
k = Required rate of return for equity investor
G = Growth rate in dividends (in perpetuity)

The advantages of Gordon Growth Model are the Model is especially useful for companies that have a great cash inflow and the company has stability with dependable leverage patterns.The valuation can be easily performed since the inputs of data for Gordon’s Growth model are readily available for computation.

The disadvantages of Gordon Growth model are the Model’s simple calculations can prove to be the major disadvantage as the model takes into consideration the quantitative figures and not the qualitative ones. The future changes cannot be taken into consideration which is why this model is not much preferred.The calculations are basically on future assumptions, which can be subjected to market changes based on the economic conditions and various other factors which contribute to being one of the major disadvantage.The limitations to the model make it less favorable for market and companies which has rapid changing dividend patterns.This is why in spite of definite success with the companies that have a high cash flow in the company this model is not suitable for many other companies which are fast growing since it is not flexible enough to include the possible fluctuations in the dividend rates in the future. This model is especially not suited for companies that are in segregation but for companies that have a heavy cash in flow and out flow ratio.

Income based Valuations - Price earnings ratio

P/E ratio model is a valuation ratio of a company's current share price compared to its per-share earnings.

Calculated as:

Market Value per Share / Earnings per Share (EPS)

A high P/E suggests that investors are expecting higher earnings growth in the future compared to companies with a lower P/E. However, the P/E ratio doesn't tell us the whole story by itself. It's usually more useful to compare the P/E ratios of one company to other companies in the same industry.

The P/E is a measure of how highly valued the company’s earnings are in the market by telling you

1. what an investor is prepared to pay for every £1 of those earnings and
2. how many years an investor would have to wait to get back his investment through current earnings (assuming all earnings are paid out as dividends, which would be somewhat unusual of course!).

Unlike other metrics such as cash flow and dividends, earnings can be subject to manipulation at company level, which means P/E can be distorted depending on how the company has accounted for particular items… The fact that accounting standards vary from country to country only adds to that problem. Warren Buffett instead judges performance using “owner earnings“, which is defined as:

• net income

• plus non-cash charges of depreciation and amortization

• less capital expenditures and any additional working capital that might be needed.

Buffett argues that owner earnings reflect the true cash flow generation of a company.

Income based Valuations - Discounted cash flow valuation

Is a valuation method used to estimate the attractiveness of an investment opportunity. Discounted cash flow analysis uses future free cash flow projections and discounts them (most often using the weighted average cost of capital - WACC) to arrive at a present value, which is then used to evaluate the potential for investment. If the value arrived at through Discounted Cash Flow analysis is higher than the current cost of the investment, the opportunity may be a good one.

Calculated as:

Advantages of discounted cash flow valuation are it produces the closest thing to an intrinsic stock value. The alternatives to Discounted Cash flow valuation are relative valuation measures, which use multiples to compare stocks within a sector. Can apply the Discounted Cash flow model as a sanity check. Instead of trying to come up with a fair value stock price, you can enter the company's current stock price into the Discounted cash flow model and, working backwards, calculate how quickly the company would have to grow its cash flows to achieve the stock price.

There are however some disadvantages such as if the inputs - free cash flow forecasts, discount rates and perpetuity growth rates - are wrong, the fair value generated for the company won't be accurate, and it won't be useful when assessing stock prices. The model is sensitive to assumptions and not suited for short-term investing. Instead, it focuses on long-term value creation.

Conclusion

In this blog entry i have concentrated on three basic valuation methods; Stock market valuation, net asset value based valuations and income based valuations and their advantages and disadvantages for each. Dependent on the company they will use different methods to workout value, with a good company using a range of methods. A company needs to understand value and how to calculate value but this is a very difficult task especially when looking to acquire a new company as both company's need to agree on the value so which method of valuing companies is best to ensure correct value is obtained is dependent on the given business situation.

Appendix 6 - Equity vs. Debt, Which method is best to finance business growth?

The majority of businesses main goals will be to expand and grow with hope of retrieving more market share. Businesses who want to grow will need financing in place as growth can be very costly. There are two common methods which a business may want to finance the growth; Equity is one method, in the form of an investor or and the other method been debt, in the form of borrowings such as a bank loan. Below you will see the advantages and disadvantages of each method;

Equity Advantages

Choosing equity to finance the expansion for growth in a business is less risky than taking out a loan because you don't have to pay it back, and it is a good option if the business can't afford to take on debt but still wants to see expansion. Another advantage of equity is you enter into the investor's network which will add more credibility to the business. Getting investors involved in financing the growth of the business is beneficial as investors take a long-term view, and most don't expect a return on their investment immediately, Investors would rather see their funds put to good use by the business which should hopefully develop long term financial gains. With equity the business won't have to channel profits into loan repayment. There are no requirement to pay back the investment if the business fails the investor should know the risks involved before contributing funds into certain investment opportunities. Overall from choosing equity you will get the money you require to help aid in expansion and growth of the business.

Equity Disadvantages

Although there are some very good advantages for taking up equity to fund business growth there is also however some major disadvantages from choosing this method, such as equity may require returns that could be more that the rate you pay for a bank loan thus making it more expensive option. It is up to shareholders when they would like to see returns. Another disadvantage is when an investor invests within a company they require a certain amount of ownership and with a percentage of profits. A business will not want to give up this kind of control. Equity funded businesses can make decision process longer as and major decisions should be consulted with investors to make sure it abides by their interests and if does not this may cause disagreements thus making decision making process much longer. Also finding the right investor for the company can take a lot of time and effort if the business is performing poor and looks less attractive on the financial statements this will put investors off from investing within the business making the process very long to raise the capital the business needs for expansion.

Debt advantages

The advantages of using debt to finance growth of a business are the bank which the company retrieves the bank loan from has no say in the way the business should be run and does not take any ownership of the business. The relationship between the bank and the business will end once all the repayments of the loan have been made. The business will pay interest on the loan but this is tax deductible. Depending on the plans for growth the loans can be agreed to be short term or long term. The business is not required to hold meetings with shareholders and does not have to seek votes before taking certain actions which makes the decision making process quick and can quickly react to the market needs.

Debt Disadvantages

Some good advantages given in the above paragraph but debt funding of business growth has major disadvantages; such as the money borrowed must be paid back within a fixed amount of time. Also relying too much on debt when the business has cash flow troubles, can put the company at risk of unable to pay back the borrowed money. Carrying too much debt will be reflected on the company's financial statements and will put off potential investors and they will consider the company to be "high risk", which will limit the business ability to raise capital by equity financing, if the business also wishes to use this method as well. Debt financing will leave the business vulnerable during hard times if sales fall. Choosing debt to fund business growth can actually make it very difficult for the business to grow because of the high costs of repaying the borrowed money. If the borrowed money is not repaid within the agreed time, assets can be held as collateral to the lender and the owner of the business is often required to personally guarantee repayment of borrowings.

Conclusion

From the above arguments for both advantages and disadvantages for equity financing and debt financing of business growth i don't believe that one method is better at raising capital than the other. Often in businesses they will use both equity and debt financing to meet the business needs when expanding. The two forms of financing together can work very well to reduce the downsides of each method. The right method or how much financing you seek from each method when using both will depend on the type of business, market the business operates in, cash flow, profits and the amount of money the business wises to seek to help grow the business. I would advise a business who seeks growth to use both equity financing and debt financing to reduce the drawbacks of each method and neither way is better than the other at getting access to more capital.

Appendix 3 - Is Modern Portfolio theory still relevant in today's markets?

In my previous blog post titled 'Capital Asset Pricing Model (CAPM)' I talked about the financial characteristics of this process with the model been able to workout the relationship between the risk and expected return on a given investment. One way a investor can reduce risk is use Modern Portfolio Theory.

What is Modern Portfolio Theory?
Modern Portfolio Theory is a theory that states investors should create an investment portfolio to spread the risk over a range of assets. The theory was developed in the 1950's which was developed by Harry Markowitz in his paper 'Portfolio Selection'. The theory is like the saying 'Don't put all your eggs in one basket'. If the investor just invests all his capital into the one investment opportunity and the investment is risky and the investment does not work this loses the investor all their capital. With Modern Portfolio Theory the investor will invest in several investment opportunities this constructing the investor a 'portfolio' to optimize expected return on a given level of market risk. The investor has also spread the risk across all the investors investments as they have not placed all their capital into the one investment. When using the theory you assume that the investor is risk averse meaning that they are reluctant to take risks. The theory is considered one of the most important and influential economic theories dealing with finance and investment.

Two Kinds of Risk
Modern portfolio theory states that the risk for individual stock returns has two components:

Systematic Risk - These are market risks that cannot be diversified away. Interest rates, recessions and wars are examples of systematic risks.

Unsystematic Risk - This risk is specific to individual stocks and can be diversified away as you increase the number of stocks in your portfolio (see below diagram). It represents the component of a stock's return that is not correlated with general market moves.




For a well-diversified portfolio, the average deviation from the mean of each stock contributes little to portfolio risk. Instead, it is the difference between individual stock's levels of risk that determines overall portfolio risk. As a result, investors benefit from holding diversified portfolios instead of individual stocks. Understanding and knowing the risks is important as to be able to mitigate them when choosing securities, helping the investor to choose the optimal portfolio.

The efficient frontier is then used to identify the combination of securities which will produce the best outcome. Below diagram is an illustration of the efficient frontier curve. The diagram shows when less risk is taken, the lower the expected return and in contrast the higher the risk taken, the higher the expected return would be. The dots nearest to the curve show the optimal combinations of securities,these are the securities that will interest investors the most, whereas the dots furthest away represent portfolios which will either offer the same returns with more risk or less return for the same risk thus interesting investors less as the portfolios are more risky or offer less returns.

Issues with Modern Portfolio Theory
The theory requires investors to rethink notions of risks. The theory can sometimes demand that the investor take on a perceived risky investment in order to reduce overall risk. Sometimes investors will not want to do this especially if they are not familiar with the benefits of sophisticated portfolio management techniques.

Another issue with modern portfolio theory is that it uses past information to help predict future trends, which is not an accurate method as it can not predict future events.  For investors who have seen their portfolios successful this could just be down to luck rather than strategies, because otherwise they would all be consistently successful and the drawbacks wouldn't be so apparent.
Modern Portfolio Theory assumes that is is possible to select certain stock whose individual performance is independent of other investments in the given portfolio. But market experts have shown that there is no such tool as in times of market stress independent investments do in fact as though they are related.It is logical to borrow to hold a risk-free asset and increase your portfolio returns, but finding a truly risk-free asset is another matter.

Government-backed bonds are presumed to be risk free but in reality they are not. They are free of default risk, but expectations of higher inflation and interest rate changes can both affect their value.

Many people ask how many stocks are required to be purchased for diversification, Mutual funds can contain a vast amount of stocks. Investment guru William J. Bernstein says that even 100 stocks is not enough to diversify away unsystematic risk. By contrast, Edwin J. Elton and Martin J. Gruber, in their book "Modern Portfolio Theory And Investment Analysis" (1981), conclude that you would come very close to achieving optimal diversity after adding the twentieth stock.

Alternative to Modern Portfolio Theory
One alternative to Modern Portfolio Theory is 'timing the market'. This is the principle that you hold on to an asset when the value is good and been able to deliver good returns and when the value of the asset starts to go bad and decreases by a certain margin then you sell the asset to not suffer any further loss in value. This alternative method can also deliver huge capital gains for the investor but it is very hard to predict future trends and how certain markets act therefore investors will want pay very close attention to the market of the asset to make sure they sell at the correct time.

Is Modern Portfolio Theory still relevant in today's markets?
The financial crisis of 2007-2008 has made many question Modern Portfolio Theory. Many years ago Modern Portfolio Theory was very much accepted but of recent times new scenarios had appeared which have proven that Modern Portfolio Theory does not always work and the theory is very much outdated.

I personally believe that the theory has been harshly criticized during the financial crisis, assets which lost all there value during the crisis would have had a negative affect against Modern Portfolio theory making investors question the theory. I would counter argue against the criticism saying that diversifying the investors portfolio offered much more protection against investors assets than holding on to single investments during the financial crisis, all though many investors would have lost value on the majority of the assets during the hard times of the financial crisis the investor may have had bad news with one asset but be compensated, by some extent of a another asset not suffering as badly during the financial crisis.

Conclusion

Modern Portfolio Theory imply's the market is hard to beat and that the investors who beat the market are those who take above-average risk. But the risk taking investors are punished when markets turn down not performing well. We need to remember that Modern Portfolio Theory is simply that it is just a theory. A portfolio's success will rest on the investor's skills and the time they spend on the portfolio making the correct decisions and careful monitoring. Some people believe that an investor should look to pick out-of-favor investments and wait for that market to start to perform well and turn in the investors favor than just on market averages alone.

The theory was heavily criticized during the financial crisis but i believe that the theory would have helped a number of investors as they have diversified their portfolio meaning that assets in certain markets would have obviously reduced to having no value but some of the assets held may have not been heavily hit. The theory however is based off past information which is not good to predict future trends. I back the main principle of this theory and by not investing all the investors capital in the one asset but instead investing in many assets creating a 'portfolio' the investor has then spread the risk of losing all their capital and be able to see certain returns from different assets in different markets, so long as the investor has chosen the correct asset to invest. 

Appendix 2 - Capital Asset pricing model (CAPM), Useful or Useless?

Capital Asset pricing model is a model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.



The general idea behind capital asset pricing model is that investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a certain amount of time. The other half of the formula represents risk and calculates the amount of compensation the investor requires for taking on additional risk. This is calculated by taking a risk measure (beta) that compares the returns of the asset to the market over a period of time and to the market premium (Rm-rf).

Investors expect a risk premium for taking on risk above the risk free rate. Say that the expected return on a risk free asset, such as a government bond is 8%. You can earn 8% by investing into this type of asset without the risk of losing your money, as government bonds are assumed to be a safe investment. However, if a company wishes for you to invest into their company (by purchasing stocks) then they need to offer you a higher rate of return (a return above the risk free rate), as there is a risk that you will lose the capital you invested or won’t receive the expected returns you were promised. The additional return you receive for taking on the additional risk is referred to as the risk premium.

Graphing Capital Asset pricing model



Above table taken from Investopedia's official website indicates that the higher the risk the higher the returns for investors. Vertical axis measures the return of investment while the horizontal axis measures the risk taken.

Useful or Useless?
The capital asset pricing model has many critics. They cite expectations such as investors borrowing unlimited amounts at the risk-free rates, limitations which make for unrealistic assumptions and, ultimately, there are more accurate models such as APM or multifactor. It also is a one-period model and only looks at one moment in time and for these reasons many argue that the capital asset pricing model should no longer be the popular return-on-investment financial tool.

However many also believe in using capital asset pricing model.

In 2008 NY Times writer Paul Krugman described the CAPM as follows:

The theoretical model that finance economists developed by assuming that every investor rationally balances risk against reward — the so-called Capital Asset Pricing Model, or CAPM (pronounced cap-em) — is wonderfully elegant. And if you accept its premises it’s also extremely useful. CAPM not only tells you how to choose your portfolio — even more important from the financial industry’s point of view, it tells you how to put a price on financial derivatives, claims on claims. The elegance and apparent usefulness of the new theory led to a string of Nobel prizes for its creators, and many of the theory’s adepts also received more mundane rewards: Armed with their new models and formidable math skills — the more arcane uses of CAPM require physicist-level computations — mild-mannered business-school professors could and did become Wall Street rocket scientists, earning Wall Street paychecks.To be fair, finance theorists didn’t accept the efficient-market hypothesis merely because it was elegant, convenient and lucrative. They also produced a great deal of statistical evidence, which at first seemed strongly supportive.

Many academic papers have investigated the real benefits of the CAPM. Douglas Breeden investigated the "empirical implications of the consumption orientated capital asset pricing model." What they found was that the CCAPM and the more standard CAPM performed similarly. Their paper Empirical Tests of the Capital Orientated CAPM was published in 1989 which shows how the CAPM's limited scope has been noticed before.

In conclusion, CAPM is a very good model for calculating risk and calculating return on investment, It has had much success over the last couple of decades but clearly has some limitations such as only looking at one period of time. An investor should look to use a range of models which will aid in making decisions and helping the investor fully understand the risks involved thus helping to reduce the riskiness of investing. Overall CAPM is a great model which determines the risks involved with certain investments and the likely capital return from taking part in the investment opportunity.

Appendix 1 - Shareholder Wealth Maximisation vs. Profit Maximisation

There are a number of different characteristics between wealth maximisation and profit maximisation.

Profit Maximisation is a more traditional approach which is often seen as the main goal of any business. The objective of financial management is profit maximisation. It cannot be the sole objective of a company as there is a relationship between risk and profit. If profit maximisation is the only goal, then risk factors are ignored. Maximising profit can help the business to survive, pay any debt, pay the businesses employees, basically profit maximisation is equal to revenue minus any expenses which the company may occur. If the business is not making any significant profit then overall the business is in danger of surviving. Profit maximisation is more short term based to gain short term returns. Profit maximisation is not very specific as there are many profits such as profit before tax, net profit and gross profit.

Wealth Maximisation is more of a modern approach with many arguing that is is more superior than profit maximisation. According to Arnold, He believes maximising wealth can be defined as maximising purchasing power and to maximise purchasing power companies pay a flow of dividends to investors who are interested in the long term gains and sustainability of the company rather than short term gains.Wealth maximisation simply means maximising the shareholders overall wealth. When the overall value of a business increases also does the shareholders wealth. Wealth maximisation serves a purpose towards shareholders objectives of getting good return and safety of their capital which they have invested, Profit maximisation does not do this. Wealth Maximisation is for long term gains. Wealth maximisation considers the time value of money, a certain amount of money valued today will be valued differently in a years time. Future cash flows will be discounted at an appropriate discounted rate to represent their present value. When talking about wealth we simply mean wealth is equal to the cash flows subtracted by costs. Wealth maximisation strategy involves making sound financial investment decisions which take into consideration risk factors.

Jensen 'Enlightened' theory

Michael Jensen in his enlightened shareholder value theory explains that a business must take into account competing interests and stakeholders cannot be ignored. Wealth and profit maximisation are intended for shareholders, but to ensure shareholders are receiving money the business must not ignore any interests of stakeholder who have interest in the business or this could have a negative impact on the money the shareholders receive.He also goes on to explain that the key ways to create value are business vision, competitive and organisational strategy 

Tesco over stating profit situation
Arnold has argued that one difference between profit maximisation and wealth maximisation is “profit is a concept developed by accountants to aid decision making, one decision being to judge the quality of stewardship shown over the owner’s funds.” Companies accounts are not always accurate as Tesco are currently in crisis due to the company inflating the profits by 250 million pounds in the first half of the year. To tie in with what Arnold said in the above statement Tesco overvaluing the profit will lead to wrong decision making as the company may believe they have more profit to play with than they actually have. Also Tesco managers have shown very poor stewardship over the owner's funds. The situation Tesco are in has caused Tesco to suspend four senior executives and call in accountancy firm Deloitte and law firm Freshfields who are to investigate this crisis that Tesco have found themselves in. Tesco have seen that they have lost 2.2 billion pounds from the value of the company. Many shareholders have walked away from the company with the major shareholders having a lot of unanswered questions which they demand to be answered from Tesco's managers. The Sunday Telegraph recently reported that one of Tesco's largest shareholders, Harris Associates, has sold around two thirds of its stake, saying the business currently lacks a clear strategy.

One of the four men suspended was Chris Bush, the most senior executive outside the Tesco boardroom as the manager who oversees its UK operations, which rang up sales of £48bn last year. “We have uncovered a serious issue and have responded accordingly,” said Tesco’s chief executive, Dave Lewis who admitted he did not yet know whether the practice had been going on for some time.

Above graph shows Tesco's share price over the last year with the over estimate of profits clearly affecting shares with share value in October 2014 clearly less than half the value they were in October 2013.

Summary
Overall wealth maximisation is better for shareholders than profit maximisation as wealth maximisation is more stable which offers greater market performance which delivers long term financial gains for the shareholders. Many consider that wealth maximisation also helps with reaching other business objectives. Total profits are not important as earnings per share.

Appendix 8 - Do internal employees who share ownership within their company hold the key to the companies success?

Many companies have employed a certain structure within their company which sees employees having a share in ownership. As well as working a day-to-day job for the company employees also have ownership of the company.

The advantages of employees having a share of ownership are employees who have ownership think more about business needs rather than personal needs. The employees are also more motivated to drive company success with most of the employees often working for the company for their whole careers meaning lower staff turnover and less cost towards the company. Employees who have ownership often make changes to satisfy customers meaning greater customer satisfaction and often look at ways to beat the competition

John Lewis & Waitrose group Success story

John Lewis is a company that offers share in ownership to their employees. They have seen from offering ownership to employees that they have sought advantages over their completion especially during the Christmas and New Year’s period. They have gained advantages over the competition as the employees are shareholders in the company therefore they will work longer hours during this period to gain more sales and this therefore affects their annual bonus over the year while offering a positive attitude to customers’ demands by offering flexibility during these busy times over the Christmas and New Year period. In 2010 employees with ownership received an annual bonus of 15% of their salary. Ms Armstrong who is the manager of Waitrose supermarket in Witney has said that business is still growing and due to VAT increase and higher inflation the rivals are getting jealous eyeing up the John Lewis and Waitrose growth. Ms Armstrong said “It’s about what sets us apart. It’s the quality of staff that we have, and the services that they give. The reason they give that service is because they do own the business”.

Delta Airlines Failure

Delta Airlines was another company which did also offer ownership to their employees but the company filed for bankruptcy in 2005. The reason behind the failure was due to the following reasons: Higher fuel costs impacted the company as well as all the companies in the airline industry. Low-fare competitors were stealing competition consumers from Delta and Delta was unable to offer the same low-fare to customers. New expensive security measures were introduced especially in America after the terrorist attack on the twin towers. 

Delta Airlines failure can be summed up that it was unable to keep up with the competition and unable to work with the day-to-day costs of running the airline hence why the company failed. Employees who also had shares in ownership of Delta may have lost their jobs along with their shares been worth nothing due to the company filing for bankruptcy. The company did however manage to exit bankruptcy in 2007 due to a management overhaul, aggressive cost cutting and merging with North West airlines which helped with the companies sustainability. The employees who remained with the company took wage cuts to help support the company during this difficult time. Delta did learn that it needed the right management team in place to help the company aim for success the management team before bankruptcy was not good at reacting to the ever changing business environment. Overall the company is currently going strong and the employees who share ownership are helping to guide the company to not suffer a further failure and instead remain competitive in the airline market.

Summary

Overall giving employee’s share of ownership making the employee a shareholder can be advantageous to the company, employees and customers as with the case with John Lewis and Waitrose group but in other cases such as Delta external influences can heavily impact the company you work for and have share of ownership for and the external influences in this case was rising costs and been unable to compete with competition in the airline industry.

Do internal employees who share ownership within their company hold the key to the companies success? Yes in some cases it does but also in other cases it does not. A company needs to also take into consideration external stakeholders such as competition as this can heavily affect the overall success of the company. A company must have a effective strategy on how the company is going to reach the company's needs as well as their targets. The company also needs finance to survive and to be able to grow in the market. The company also must have the capabilities to survive in the market and must be able to change to meet market needs and to attract consumers to gain sales.

Appendix 9 - Do internal shareholders hold the key to company success? (Test blog entry)

(Below is test blog)
Many companies have employed a certain structure within their company which sees employees having a share in ownership. As well as working a day-to-day job for the company employees also have ownership of the company.

The advantages of employees having a share of ownership are;

•  Employees who have ownership think more about business needs rather than personal needs.
•  Employees who have ownership also more motivated to drive company success.
•  Employees who have ownership often work for the company for their whole careers meaning lower staff turnover and less cost towards the company.
•  Employees who have ownership often make changes to satisfy customers meaning greater customer satisfaction and often look at ways to beat the competition.

John Lewis & Waitrose group Success story

John Lewis is a company that offers share in ownership to their employees. They have seen from offering ownership to employees that they have sought advantages over their completion especially during the Christmas and New Year’s period. They have gained advantages over the competition as the employees are shareholders in the company therefore they will work longer hours during this period to gain more sales and this therefore affects their annual bonus over the year while offering a positive attitude to customers’ demands by offering flexibility during these busy times over the Christmas and New Year period. In 2010 employees with ownership received an annual bonus of 15% of their salary. Ms Armstrong who is the manager of Waitrose supermarket in Witney has said that business is still growing and due to VAT increase and higher inflation the rivals are getting jealous eyeing up the John Lewis and Waitrose growth. Ms Armstrong said “It’s about what sets us apart. It’s the quality of staff that we have, and the services that they give. The reason they give that service is because they do own the business”.

Delta Airlines Failure

Delta Airlines was another company which did also offer ownership to their employees but the company filed for bankruptcy in 2005. The reason behind the failure was due to the following reasons;

• Higher fuel costs
• Low-fare competitors 
• New expensive security measures

Delta Airlines failure can be summed up that it was unable to keep up with the competition and unable to work with the day-to-day costs of running the airline hence why the company failed. Employees who also had shares in the company may have lost their jobs along with their shares been worth nothing due to the company filing for bankruptcy. The company did however manage to exit bankruptcy in 2007 due to a management overhaul, aggressive cost cutting and merging with North West airlines which helped with the companies sustainability. The company is still in the business world today.

Summary

Overall giving employee’s share of ownership making the employee a shareholder can be advantageous to the company, employees and customers as with the case with John Lewis and Waitrose group but in other cases such as Delta external influences can heavily impact the company you work for and have share of ownership for and the external influences in this case was rising costs and been unable to compete with competition in the airline industry.