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.