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Corporate and International Finance

Assignment No.1 RISK ANDMARKET ANALYSIS OF TWO COMPANIES THAT OPERATE IN DIFFERENT SECTORS OF THE UK ECONOMY.(BY CAPM AND BETA VALUE)

SUBMITTED BY:

ANOOP SAXENA

Page 1 of 25

K0226432

SUBMITTED TO:

Dr Yongsheng Guo

Contents Introduction Companies’ profile

• Tesco profile • Royal Bank of Scotland What is Beta? Calculation of beta for Tesco Calculation of beta for Royal Bank of Scotland Required rate of return Calculation of expected rate of return Significance and assumption of CAPM Acceptability or Implication of CAPM Page 2 of 25

Conclusion Reference Bibliography Appendix

Introduction In the mid-1960s, the three economists- William Sharpe, John Lintner, and Jack Treynor, found the simple equation to calculate the risk and expected return on the investment of capital. This model or equation is known as the Capital Asset Pricing Model (CAPM). Capital Asset Pricing Model (CAPM) is the model used to describe the relation between the risk and expected return on the investment. It helps the investors to determine the appropriate price of the investment Ri=Rf+βRm-Rf

Ri = rate of expected return Rf = risk free return (treasury bills, libor rate) Rm =rate of market return  = beta value of company

Page 3 of 25

CAPM is a simple but powerful model. Moreover it takes into the basic principles of portfolio selections:

• Efficient portfolios (Maximize excepted return subject to risk). • The highest risk premium to standard deviation is a combination of the market portfolio and the riskfree asset. • Individual stocks should be selected on their contribution to portfolio risk. • Beta measures the marginal contribution of the stock to the market portfolio. Page 4 of 25

Companies’ profile Tesco profile Tesco is one of the major grocery retail company. With its subsidiaries, it operates in various foods, non-food, and other retailing services. The Tesco is the thirdlargest retailer in the world measured in terms of revenue, after Wal-mart and Carrefour. And second largest in terms of profit after Wal-mart. There are more than 4811 stores across the globe( United Kingdom, the Republic of Ireland, Hungary, Poland, the Czech Republic, Slovakia, Turkey, Thailand, South Korea, Malaysia, Japan, China, India, and the United States). The company was founded by Jack Cohen in 1919. And opens its first store in 1929 in Burnt Oak, Edgware, Middlesex. The store operates over 40,000 product line. The store operates in multi-store formats across the United Kingdom. The stores sales all kinds of products that includes food, non food, wines and spirits, electrical equipments, home entertainment, cosmetics, pharmaceutical products and clothing’s and others products.

Royal Bank of Scotland The Royal Bank of Scotland Group plc, through its subsidiaries, offers banking and financial services to Page 5 of 25

personal, commercial, corporate, and institutional customers in the United Kingdom, the United States, and internationally. Royal Bank of Scotland has around 700 branches, mainly in Scotland though there are branches in many larger towns and cities throughout England and Wales. It provides private banking and investment services, and offshore banking services; and debt and equity financing and risk management services, as well as money markets, currencies and commodities, equities, credit markets and portfolio management and origination services. The company also offers global payments, cash and liquidity management, and trade finance and commercial card products and services; sells and underwrites retail and SME insurance over the telephone and Internet, as well as through brokers and partnerships; and offers general insurance, including motor insurance under the brands of Direct Line, Churchill, Privilege, Green Flag, and NIG. In addition, it provides operational technology, customer support in telephony, account management, lending and money transmission, global purchasing, property, and other services. The company was founded in 1727 and is headquartered in Edinburgh, the United Kingdom. The Royal Bank of Scotland Group plc operates as a subsidiary of HM Treasury

What is Beta? Page 6 of 25

“The market risk is measured by Beta; it shows the sensitivity of the return is to the market movements. Beta measures the risk of an asset relative to the average asset. By definition the average assets have the beta value 1, relative to itself.” Beta can be defined as – “a quantitative measure of the volatility of a given stock, mutual funds, or portfolio, relative to the overall market. Specifically, the performance of the stock, fund, or portfolio has experienced in the last 5 years as the market moved 1% up or down. A beta above 1 is more volatile than the beta whose value is less than 1.”( investorwords) Beta value of a stock can take one of the following forms. 1. Negative Beta – This is a rarity, and means the stock is moving just reverse to the market. 2. Zero (0) Beta – This means the value of the stock stays same irrespective of market movement. Again a rarity. 3. Beta between 0 and 1 – This means the stock price swing less compared to market movements. Many blue chip company stocks and high-liquidity stocks have beta less than one. In a long-term prospective these stocks fall under low-risk lowprofit category. 4. Beta of 1 – This means the stock price moves in the same relation with the market. This can be the case with many index-related products. 5. Beta greater than 1 – This means the stock price swings more compared to market movements. Page 7 of 25

Many growing companies and technology companies have beta greater than one. Most of these stocks fall under high-return high-risk category. Also remember, beta at very high levels probably indicates high price volatility because of low-liquidity. Formula of beta(β ) β=cov(rs,rm)var(rm) rs=rate of return of stock(for given time) rm=rate of return of market(for given time)

Calculation of beta for Tesco The beta of Tesco is calculated by the use of excel slope formula.

Date

Adj Close tesco l

Adj Close ftse 100

01-12-2010

425

5899.9

01-11-2010

414.3

5528.3

01-10-2010

426.85

5675.2

01-09-2010

424

5548.6

02-08-2010

405.61

5225.2

01-07-2010

390.65

5258

01-06-2010 04-05-2010

380.05 411.6

4916.9 5188.4

return of tesco

return of ftse 100

(B3/B4-1) 0.025826 696 0.029401 429 0.006721 698 0.045339 119 0.038295 149 0.027891 067 0.076652 089 0.054119

(C3/C4-1)

beta of tesco for 5yrs slope(return of tesco,return of market)

0.06721777

0.783190952

Page 8 of 25

-0.02588455 0.022816566

beta for year2010

0.061892368 0.006238113

0.616389636

0.069372979

beta for year2009

0.052328271 0.065708678

0.507950734

01-04-2010

435.15

5553.3

01-03-2010

435.45

5679.6

01-02-2010

419.7

5354.5

04-01-2010

424.55

5188.5

01-12-2009

428

5412.9

02-11-2009

423

5190.7

01-10-2009

408.49

5044.5

01-09-2009

399.6

5133.9

03-08-2009

375.9

4908.9

01-07-2009

367.35

4608.4

01-06-2009

353.6

4249.2

01-05-2009

364.9

4417.9

01-04-2009

337.2

4243.7

02-03-2009

333.4

3926.1

02-02-2009

333.2

3830.1

02-01-2009

358.2

4149.6

01-12-2008

360

4434.2

03-11-2008

295.3

4288

01-10-2008

339.4

4377.3

01-09-2008 01-08-2008

387.6 381.5

4902.5 5636.6

269 0.000688 942 0.037526 805 0.011423 861 0.008060 748 0.011820 331 0.035521 065 0.022247 247 0.063048 683 0.023274 806 0.038885 747 0.030967 388 0.082147 094 0.011397 72 0.000600 24 0.069793 412 -0.005 0.219099 221 0.129935 18 0.124355 005 0.015989 515 0.058546 Page 9 of 25

0.022237482

beta for year2008

0.060715286

1.156637854

0.031993833 0.041456521

beta for year2007

0.042807328

1.008567269

0.02898206 0.017413662

beta for year2006

0.045835116

0.24431558

0.065207013 0.084533559 0.038185563 0.041049085 0.080894526 0.02506462 0.076995373 0.064182942 0.034095149 0.020400704 0.107129016 0.130238087 0.0415196

01-072008

360.4

5411.9

02-062008

369.3

5625.9

414.1

6053.5

429

6087.3

03-032008

379

5702.1

01-022008

400.5

5884.3

01-012008

417

5879.8

03-122007

477.25

6456.9

479

6432.5

01-052008 01-042008

01-112007 01-102007 03-092007

488

6721.6

439.25

6466.8

01-082007

425

6303.3

02-072007

407.75

6360.1

01-062007

418.5

6607.9

458.75

6621.4

462.5

6449.2

444.25 432

6308 6171.5

01-052007 02-042007 01-032007 01-022007

06 0.024099 648 0.108186 428 0.034731 935 0.131926 121 0.053682 896 0.039568 345 0.126244 107 0.003653 445 0.018442 623 0.110984 633 0.033529 412 0.042305 334 0.025686 977 0.087738 42 0.008108 108 0.041080 473 0.028356 481 0.033492 823 Page 10 of 25

14 0.03803835 8 0.07063682 2 0.00555254 4 0.06755405 9 0.03096375 1 0.00076533 2 0.08937725 5 0.00379323 7 0.04301059 3 0.03940124 9 0.02593879 4 0.00893067 7 0.03750056 8 0.00203884 4 0.02670098 6 0.02238427 4 0.0221178 0.00509422

01-012007 01-122006

418

6203.1

404.5

6220.8

391.25

6048.8

393.5

6129.2

360

5960.8

377.25

5906.1

359.5

5928.3

334

5833.4

01-052006

320.5

5723.8

03-042006

313.44

6023.1

323.74

5964.6

331.59

5791.5

311.97

5760.3

01-112006 02-102006 01-092006 01-082006 03-072006 01-062006

01-032006 01-022006 02-012006

total (Σ)

0.033374 536 0.033865 815 0.005717 916 0.093055 556 0.045725 646 0.049374 131 0.076347 305 0.042121 685 0.022524 247 0.031815 655 0.023673 814 0.062890 663

0.421934 192

7 0.00284529 3 0.02843539 2 0.01311753 6 0.02825124 1 0.00926161 1 -0.00374475 0.01626838 6 0.01914811 8 0.04969201 9 0.00980786 6 0.02988863 0.00541638 5

0.09018803 7

The values of beta for Tesco are as follows:YEAR

BETA VALUE OF TESCO

2006-10

0.783190952

2010

0.616389636 Page 11 of 25

2009

0.507950734

2008

1.156637854

2007

1.008567269

2006

0.24431558

Tesco The Tesco share is less volatile. This means the stock price swing less compared to market movements. The company stocks and high-liquidity stocks have beta less than one. In a long-term prospective these stocks fall under low-risk low-profit category. By keeping the share of Tesco in our portfolio, we can minimize the risk of loss. But on the other hand we also play down the possibility of making good profit in short period of time. The share of Tesco is good to play for long term/long period, say more than 2 years. But it not good for the professional traders, who use to buy and sales share on daily basis. Tesco share is good for the general public, small investors, and the peoples who don’t want to take the risk on their investment. It is not 100% safe as the Treasury bill, LIBOR rate or any other government securities. Calculation of beta for Royal Bank of Scotland The beta of Royal Bank of Scotland is calculated by the use of excel slope formula. Date

Adj Close rbs l

Adj Close ftse100

return of rbsl

return of ftse 100

Page 12 of 25

beta for 5yrs

(B3/B41) 0.03937 22 0.15736 4 0.06301 2 0.06796 77 0.10768 6 0.20588 95 0.11341 8 0.14020 2

01-122010

39.07

5899.9

01-112010

37.59

5528.3

44.61

5675.2

47.61

5548.6

44.58

5225.2

49.96

5258

01-062010

41.43

4916.9

04-052010

46.73

5188.4

54.35

5553.3

44

5679.6

37.67

5354.5

04-012010

32.3

5188.5

01-122009

29.2

5412.9

02-112009

33.18

5190.7

01-102009

41.99

5044.5

52.95

5133.9

57.65

4908.9

0.10616 44 0.11995 2 0.20981 2 0.20698 8 0.08152 6 0.28539 58

44.85

4608.4

0.15059

01-102010 01-092010 02-082010 01-072010

01-042010 01-032010 01-022010

01-092009 03-082009 01-072009

0.23522 73 0.16803 82 0.16625 39

Page 13 of 25

(C3/C4-1) 0.0672177 7 0.0258845 5 0.0228165 66 0.0618923 68 0.0062381 13 0.0693729 79 0.0523282 71 0.0657086 78 0.0222374 82 0.0607152 86 0.0319938 33 0.0414565 21 0.0428073 28 0.0289820 6 0.0174136 62 0.0458351 16 0.0652070 13 0.0845335 59

slope(return of RBS,return of FTSE) 2.232457592

beta for year2010 1.528353377

beta for year2009 3.20285309

beta for year2008 1.870793735

beta for year2007 0.594055001

beta for year2006 1.073393588

01-062009 01-052009 01-042009 02-032009

38.98

4249.2

38.2

4417.9

41.8

4243.7

24.5

3926.1

02-022009

23.2

3830.1

02-012009

22

4149.6

01-122008

49.4

4434.2

03-112008

55.3

4288

01-102008

67.5

4377.3

0.02041 88 0.08612 4 0.70612 24 0.05603 45 0.05454 55 0.55465 6 0.10669 1 0.18074 1 0.62290 5 0.23748 7 0.10861 87 0.01511 6 0.05908 1 0.33768 1

01-092008 01-082008

179

4902.5

234.75

5636.6

01-072008

211.75

5411.9

02-062008

215

5625.9

228.5

6053.5

345

6087.3

337.25

5702.1

385

5884.3

0.02298 0.12402 6 0.00785 34

382

5879.8

0.13964

01-052008 01-042008 03-032008 01-022008 02-012008

Page 14 of 25

0.0381855 63 0.0410490 85 0.0808945 26 0.0250646 2 0.0769953 73 0.0641829 42 0.0340951 49 0.0204007 04 0.1071290 16 0.1302380 87 0.0415196 14 0.0380383 58 0.0706368 22 0.0055525 44 0.0675540 59 0.0309637 51 0.0007653 32 0.0893772 55

03-122007

444

6456.9

01-112007 01-102007

459

6432.5

516.5

6721.6

03-092007

525

6466.8

01-082007

574.5

6303.3

02-072007

592.5

6360.1

01-062007

633

6607.9

01-052007

627.5

6621.4

02-042007

643

6449.2

01-032007

661

6308

01-022007

669

6171.5

681

6203.1

664

6220.8

613

6048.8

622

6129.2

612

5960.8

593

5906.1

580 592

5928.3 5833.4

02-012007 01-122006 01-112006 02-102006 01-092006 01-082006 03-072006 01-06-

0.03268 0.11132 6 0.01619 0.08616 2 0.03038 0.06398 1 0.00876 49 0.02410 6 0.02723 1 0.01195 8 0.01762 1 0.02560 24 0.08319 74 0.01446 9 0.01633 99 0.03204 05 0.02241 38 0.02027 0.03135

Page 15 of 25

0.0037932 37 0.0430105 93 0.0394012 49 0.0259387 94 0.0089306 77 0.0375005 68 0.0020388 44 0.0267009 86 0.0223842 74 0.0221178 0.0050942 27 0.0028452 93 0.0284353 92 0.0131175 36 0.0282512 41 0.0092616 11 0.0037447 5 0.0162683 86 0.0191481

2006 02-052006 03-042006 01-032006 01-022006 03-012006

574

5723.8

596

6023.1

624

5964.6

582.73

5791.5

530.51

5760.3

89 0.03691 3 0.04487 2 0.07082 18 0.09843 36

1.41182 2

total()

market return (%) rm

9.0188 04

treasury bill rate (%) 5 years rf

2.24

expected rate of return Rj

17.373 39

18 0.0496920 19 0.0098078 66 0.0298886 3 0.0054163 85

0.0901880 37

The values of beta for Royal Bank of Scotland are as follows:YEAR

BETA VALUE OF Royal Bank of Scotland

2006-10

2.232457592 Page 16 of 25

2010

1.528353377

2009

3.20285309

2008

1.870793735

2007

0.594055001

2006

01.073393588

The Royal Bank of Scotland share is more volatile in comparison of Tesco. This means the stock price swings more compared to market movements. Many growing companies and technology companies have beta greater than one. Most of these stocks fall under high-return high-risk category. Also remember, beta at very high levels probably indicates high price volatility because of low-liquidity.by keeping the share of Royal Bank of Scotland in our portfolio, we can maximise the profit. But on the other hand we also increase the possibility of making good loss in short period of time. The share of Royal Bank of Scotland is good to play for short term/short period, say less than six month. But it is good for the professional traders, who use to buy and sales share on daily basis. Royal Bank of Scotland share is not good for the general public, small investors, and the peoples who don’t want to take the risk on their investment. Because it is very volatile and it can’t be trusted.

Page 17 of 25

The comparison of the beta value of Tesco and Royal Bank of Scotland.( on the basis of each year) Year

TESCO

ROYAL BANK OF SCOTLAND

200610

0.783190952

2.232457592

2010

0.616389636

1.528353377

2009

0.507950734

3.20285309

2008

1.156637854

1.870793735

2007

1.008567269

0.594055001

2006

0.24431558

01.073393588

Year

Tesco

Royal Bank of Scotland

2006

The share of Tesco is very less volatile.

The share of Royal bank of Scotland is volatile but near to the ideal condition.

2007

The beta value the share reaches near to the ideal market situation

The share value becomes less volatile.

2008

Due to the recession period the share value becomes more volatile.

Due to the recession period the share value becomes more volatile.

Page 18 of 25

2009

In this period the beta value of share becomes less volatile in comparison of others

In this year the beta value of the share reaches up to the 3.2% mark.

2010

The beta value in this year remains nearly the same as the previous year

The beta value falls down to nearly half of the previous year. But still it is more volatile than the other.

As per the above the Tesco is much safer for the small investors in comparison to the Royal Bank of Scotland. But the return is also less in comparison to the Royal Bank of Scotland, when the market moves up.

Required rate of return The CAPM establishes the linear relationship between the required rate of return of a share and its systematic or undiversified risk or beta. The rate of return can be described as the minimum rate of return that an investment must provide or must be expected to provide in order to justify its acquisition. The CAPM states that the expected return of a security or a portfolio should equal the rate on a risk-free security (Treasury bond, LIBOR rate) plus a risk premium. If this expected return does not meet or exceed the required return, the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Ri=Rf+βRm-Rf

Page 19 of 25

Ri = rate of expected return Rf = risk free return (treasury bills, libor rate) Rm =rate of market return  = beta value of company The risk free rate of return can be described as the rate of return with zero risk. It is the rate of interest an investor gets or would expect from absolute risk free investment over a specified period of time. The treasury bills, LIBOR rate is considered as the risk free rate of return.

Calculation of expected rate of return • Royal bank of Scotland Ri=Rf+βRm-Rf

Ri = rate of expected return Rf = 2.24% (treasury bills) Rm =9.018804  = 2.232457592 Ri=2.24+2.232457592(9.018804-2.24) Ri= 2.24+ 2.232457592* 6.778804 Ri= 2.24+ 15.13339245447997 Ri= 17.37339245447997 The excepted rate of return of the Royal Bank of Scotland is 17.37339245447997%. The investors of Page 20 of 25

the Royal Bank of Scotland expect the rate of return on the investment is about 17.37% Tesco Ri=Rf+βRm-Rf

Ri = rate of expected return Rf = 2.24% (treasury bills) Rm =9.018804  = 0.783190952 Ri=2.24+0.783190952 (9.018804-2.24) Ri= 2.24+ 0.783190952* 6.778804 Ri= 2.24+5.309097958181408 Ri= 5.309097958181408 The excepted rate of return of the Tesco is 5.309097958181408 %. The investors of the Tesco expect the rate of return on the investment is about 5.31%

Significance and assumption of CAPM The greatest advantage of Capital asset pricing model (CAPM) is the idea that risk-return relation of every portfolio can be optimized to attain lowest risk for a specific level of return. Many investors following CAPM prefer to invest in low-cost index funds rather than on stocks. CAPM necessitates diversification of portfolio. It helps the investor to select the portfolio of its choice, whether they want to invest in low risk shares or high risk share. Or they can manage their portfolio by keeping some volatile and some less volatile shares. Page 21 of 25

Assumptions 1. If investors agree on the distribution of asset returns. 2. If Investors have the same fixed (static) investment horizon. 3. Investors hold efficient frontier portfolios. 4. There is a risk-free asset: • paying interest rate rF • in zero net supply. 5. Demand of assets equals supply in equilibrium.

Acceptability or Implication of CAPM 1. The market portfolio is the tangent portfolio. 2. Combining the risk-free asset and the market portfolio gives the portfolio frontier. 3. The risk of an individual asset is characterized by its co variability with the market portfolio. 4. The part of the risk that is correlated with the market portfolio, The systematic risk cannot be diversified away. • Bearing systematic risk needs to be rewarded. 5. The part of an asset’s risk that is not correlated with the market portfolio, the non-systematic risk, can be diversified away by holding a frontier portfolio. • Bearing non-systematic risk need not be rewarded.

Conclusion Page 22 of 25

According to the calculation of betas and CAPM the share price of Royal Bank of Scotland is more volatile in nature than the share price of Tesco. According to me the Tesco is more safe option in the portfolio, instead of Royal Bank of Scotland; for the investor who don’t want to take risk and play safe in the market. The excepted rate of return of Royal Bank of Scotland is much higher than Tesco. And for those investors who want to take the risk and earn more profit can opt for the Royal Bank of Scotland share. But they always have a risk of crashing and losing a huge amount of investment. If, I have to invest in a share, I will invest in the share of Royal Bank of Scotland; so that I can earn more profit. But I also have to keep the eye on the fluctuation of the market and Royal Bank of Scotland share price. So, that I can minimise the risk of losing my investments. Reference http://www.investorwords.com/468/beta.html : beta (accessed on 20 march 2011) W. F. Sharpe, (September 1964), “Capital Asset Prices: A Theory of Market Equilibrium under Conditions of Risk,” Journal of Finance 19 pp. 425–442 J. Lintner, (February 1965), “The Valuation of Risk Assets and the Selectionof Risky Investments in Stock Portfolios and Capital Budgets,” Review of Economics and Statistics 47 pp. 13–37.

Page 23 of 25

Treynor’s article has not been published. Helbaek, Morten Lindset, Snorre Mclellan, Brock , (2010) Corporate Finance; Pages: 164 : McGraw-Hill Education ; : Berkshire, GBR

Frank J.Fabozzi, Jack Clark Francis, (march.1978); The Journal of Financial and Quantitative Analysis, Vol.13 no.1; page 101-116

Bibliography Arnold, G. (2008), Corporate Financial Management, 4th ed., Harlow, Financial Times Prentice Hall. Bernstein, P. Capital Ideas, the Improbable Origins of Modern Wall Street. New York: Free Press, 1992.

Page 24 of 25

Fabozzi, Frank J., ed. Handbook of Portfolio Management. New York: McGraw-Hill, 1998. Fama, E., and J. MacBeth. "Risk, Return, and Equilibrium: Empirical Tests." Journal of Political Economy, no. 71 (1973). Gitman, Lawrence. Basic Managerial Finance, 3rd ed., New York: Harper Collins, 1992. Haugen, R. Modern Investment Theory. 3rd ed. Englewood Cliffs, NJ: Prentice Hall, 1993. Ibbotsen, R., and R. Sinquefield. "Stocks, Bonds, Bills, and Inflation: Year-by-Year Historical Returns (1926-1974)." Journal of Business, no. 49 (1976). Lintner, J. "The Valuation of Risk Assets and the Selection of Risky Investments in Stock Portfolios and Capital Budgets." Review of Economics and Statistics, no. 47 (1965). Markowitz, H. "Portfolio Selection." Journal of Finance, no. 7 (1952). Roll, R. "A Critique of the Asset Pricing Theory Tests—Part 1: On Past and Potential Testability of the Theory." Journal of Financial Economics, no. 4 (1977). Ross, S. "The Arbitrage Theory of Capital Asset Pricing." Journal of Economic Theory, no. 13 (1976). Schwert, G. "Size and Returns, and other Empirical Regularities." Journal of Financial Economics, no. 12 (1983). Sharpe, W. "Capital Asset Prices: A Theory of Market Equilibrium Under Conditions of Risk." Journal of Finance, no. 19 (1964).

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