Sanya (41846915), Julia (41797817), Jessica (42047471), Leon (41954998) Viewpoint 2 Joe Introduction to the question The S&P

200 is the market-capitalization weighted and float-adjusted stock market index of Australian stocks, which is listed on the Australian Securities Exchange (ASX) from Standard & Poors. It is known as the primary investable benchmark in Australia as it covers around 78% of Australian equity market capitalization. This index is designed to address the investment managers needs to benchmark against portfolio characterized by sufficient size and liquidity. However, this index is intended to reflect the changes in the share price and not changes in market capitalization. Thus if a company increases its market capitalization by issuing new shares, a Divisor is adjusted so that the index value doesnt change. There are various, well-known mining companies in Australia which include a number of large multinational companies such as: BHP Billiton (worlds largest mining company measured by revenue and market capitalization), Newcrest, Rio Tinto, Alcoa, Chalco, Shenhua (Chinese mining company), Alcan and Xstrata. Each of these mining companies is exposed to various risks which make it hard for companies to evaluate the appropriate cost of capital, for any potential investment opportunities. Risks associated with Mining Companies There are a number of risks that mining companies have to face for their future viability and profitability. Firstly, the prices of the commodities being explored tend to change constantly; depending on their demand and on the preference of investors. If there is a high demand for a particular commodity, there would be an increase in supply for those commodities, benefiting companies that supply these commodities to the market. Also, the exchange rates across the globe are constantly changing due to the economies of the particular countries, which have an effect on the prices of commodities being exported and imported. Because of this volatility in the rates, the demand for them is constantly changing, depending on the investors wealth and their preferences. Another risk faced by these mining companies include risks associated with the successful exploration and mining for these commodities, the identification of ore reserves, and the satisfactory performance of the mining operation, when the mineable deposits are discovered. There could be unforeseen operational risks such as major failures, breakdowns or repairs required to the exploration equipment and vehicles, or to the mining plant or mine structure, which might result in delays or regular repair programs. These could be very costly and risky for the mining companies as they might encounter unexpected risks while carrying out their exploration and mining. An additional risk faced is the availability and high cost of quality management, contractors and equipment for exploration, mining and corporate and administration functions. It would be costly to look for the right management and contractors team as the result of the exploration and mining depends on them and all mining companies want to look for the best team to carry out their work.

Environmental issues are another risk factor faced by mining companies as these risks are unforeseeable and can have damaging effects on the project on hand and thus, on the company. There could be poor weather conditions over a prolonged period which might affect the exploration activities of the company. This could affect the projects timing of earning revenues which is another uncertainty faced by these mining companies. Apart from these, mining companies are also faced with various legislative and regulatory regimes, to which they have to comply to in order to successfully commence and terminate their exploration activities. These companies are faced with risks of obtaining grants for their mining tenements or permits. An example can be seen in Western Australia where any mining lease granted is currently subject to a prohibition on uranium mining. In Australia, mining companies have to go through a negotiation process under the Native Title matters, which might result in a significant delay to the implementation of the project or it might even stall the project. Because of the rights of indigenous groups in the jurisdiction in which the company operates, it might affect the companys ability to gain access to the exploration sites thus affecting the successful completion of the exploration activity on hand. In conclusion, exploration activities are costly and they involve techniques which need to be applied over an extended period of time. Thus companys projects are at exploration stage and they cant foresee if the planned exploration will generate positive results or whether they will succeed in the discovery of the commodity for which they are excavating. There are various uncertainties associated with the project involving the operational and technical problems which increases the risks these mining companies have to face. In addition to this, non-technical issues add to the risks faced such as: limitations on activities due to seasonal changes, industrial disputes, land claims, legal challenges associated with Native Title, environmental matters and legislation. These factors are beyond the control of companies and the can be partly or wholly unforeseeable. Also, companies may not have sufficient development capital to cover for the cost of maintaining the exploration and mining activities which adds to another form of risks these mining companies have to face. And finally, exploration and mining activities could prove to be unsuccessful, which could results in the company having a negative impact on their share prices. Looking at these various risks these mining companies have to face, we can see the multiple risk factors that they are exposed to. This leads us to thinking about the best method to estimate the cost of capital for the potential investment. http://www.auroraminerals.com/Default.aspx?tabid=1911 http://www.standardandpoors.com/indices/sp-asx-200/en/us/?indexId=spausta200audff--pau---http://en.wikipedia.org/wiki/S%26P/ASX_200 http://en.wikipedia.org/wiki/Mining_in_Australia

Capital Asset Pricing Model (CAPM) The Capital Asset Pricing Model (CAPM) is an economic model for calculating required rate of return on an individual security or a portfolio of securities by relating risk and expected return. CAPM is based on the idea that investors demand additional expected return (called the risk premium) if they are asked to accept additional risk. This model was originally developed in 1952 by Harry Markowitz and fine-tuned over a decade later by others, including William Sharpe E(Ri) = Rf + i * (E(Rm) Rf) Or E(Ri) Rf = i * (E(Rm) Rf) The general idea behind CAPM 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 expected return of a risk-free asset (rf). It compensates the investors for placing money in any investment over a period of time. The other half of the formula represents non-systematic (or market) risk which is non-diversifiable multiplied by and the expected excess return on market efficient portfolio. So the higher the beta, the higher the expected returns needed to compensate equity investors for taking on additional market risk. In particular, it shows how much the price of a particular stock jumps up and down compared with how much the stock market as a whole jumps up and down. If a share price moves exactly in line with the market, then the stock's beta is 1. A stock with a beta of 1.5 would rise by 15% if the market rose by 10%, and fall by 15% if the market fell by 10% http://www.investopedia.com/articles/06/CAPM.asp#axzz1WT7mRF1Z The CAPM says that the expected return of a security or a portfolio equals the rate on a riskfree security plus a risk premium.

The CAPM has several advantages / benefits over other methods of calculating required return, explaining why it has been widely used by most companies over the past decade which is due to its simplicity: It generates practical and linear relationship between the return required on an investment and its risk, the higher the risk the higher the return It provides a risk-adjusted discount rate for evaluation of capital investment projects (use the discount rate to calculate NPV) It only considers systematic risk and eliminates unsystematic risk, reflecting a reality to an extent to which most investors can hold diversified portfolios that allow to them to minimize unsystematic risks It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a company's level of systematic risk relative to the stock market as a whole. the following set of assumptions:

The CAPM is only valid under (shortcomings / limitations of CAPM)

All investors have rational homogeneous expectations / beliefs about asset returns i.e. everyone has access to the same information at the same time. Security returns are normally distributed. Capital markets are perfectly efficient i.e. there are neither arbitrage opportunities nor market imperfections such as taxes, regulations or restriction on short-selling There exists a risk free asset which allow investors to borrow and lend an unlimited amount of this asset at a constant rate i.e. the risk free rate Asset markets are frictionless; information is costless and simultaneously available to all investors, implying that borrowing rate equals lending rate. Investors are only rewarded for bearing systematic risk i.e. the risk that affects all firms in the market. It also implies that they can eliminate firm-specific risks by holding a well-diversified portfolio of stocks available in the market.

http://wiki.answers.com/Q/What_are_the_advantages_and_disadvantages_of_capital_asset_p ricing_model_over_portfolio_theory#ixzz1WTPVbfgN

Arbitrage Pricing Theory (APT) In finance, arbitrage pricing theory (APT) is a general theory of asset pricing that holds that the expected return of a financial asset can be modeled as a linear function of various macro-economic factors or theoretical market indices, where sensitivity to changes in each factor is represented by a factor-specific beta coefficient. The Arbitrage Pricing Theory (APT) was introduced by Ross (1976) as an alternative to the CAPM. It is more general in the sense it allows more risk factors. The APT assumes markets are competitive and frictionless. Idiosyncratic shocks are assumed to be uncorrelated across assets and uncorrelated with the factors. The APT states that if asset returns follow a factor structure then the following relation exists between expected returns and the factor sensitivities:

where

RPk is the risk premium of the factor, rf is the risk-free rate,

Note that there are some assumptions and requirements that have to be fulfilled for the latter to be correct: There must be perfect competition in the market, and the total number of factors may never surpass the total number of assets (in order to avoid the problem of matrix singularity). Arbitrage pricing theory (APT) is a valuation model. Compared to CAPM, it uses fewer assumptions but is harder to use. Compared to CAPM, APT has several advantages: The Arbitrage pricing theory (APT) is very detailed pricing method. The APT is based on five different economical factors. The factors are: business cycle, time horizon, confidence, inflation and market timing risk. 1. The primary advantage of using the APT in portfolio selection and portfolio risk management is that the model makes the fundamental sources of risk explicit. 2. Compared to CAPM, it is less restrictive in its assumptions: The APT is derived from the premises that asset returns follow a linear returns generating process, and that in well-functioning financial markets, there will be no arbitrage opportunities. 3. Based on the theoretical base of CAPM, but more accurately reflect reality. CAPM involves sets of equations that seek to prove that the performance of the current risk portfolio matches the performance of the overall market. This will result in an ideal

performance. APT grew from the view that while CAPM provides an interesting theoretical base, it does not accurately reflect reality. APT thus borrowed from CAPMs theoretical base, but then expanded it with the real-world action of seeking undervalued products. 4. Ability to make a fair assessment of pricing of different stocks. The basic assumption of APT is that the value of a stock is driven by a number of factors. First there are macro factors that are applicable to all companies and then there are company specific factors. Drawbacks of APT: 1. Arbitrage pricing theory does not rely on measuring the performance of the market. Instead, APT directly relates the price of the security to the fundamental factors driving it. The problem with this is that the theory in itself provided no indication of what these factors are, so they need to be empirically determined. Obvious factors include economic growth and interest rates. For companies in some sectors other factors are obviously relevant as well such as consumer spending for retailers. 2. The potentially large number of factors means more betas to be calculated. There is also no guarantee that all the relevant factors have been identified. This added complexity is the reason arbitrage pricing theory is far less widely used than CAPM. 3. The Capital Asset Pricing Model (CAPM) and the Arbitrage Pricing Theory (APT) have emerged as two models that have tried to scientifically measure the potential for assets to generate a return or a loss. They are similar in that they attempt to measure an assets propensity to follow the overall market however APT attempts to divide market risk into smaller component risk. Regardless, it is very difficult to predict which companies are strategically positioned well into the future in the right growing markets from a product, market-share, distribution, and corporate culture standpoint. It is even harder if not impossible to predict what the investor publics reaction would be to such a success if you were to correctly envision it. 4. Uses data that is specific to one stock, cannot better apply theory to practice. CAPM uses lots of objective data that is widely available. APT, on the other hand, uses data that is specific to that stock. This is better in theory, but in practice it is difficult to determine which data is important and which data is not, and to what factor it is an influence. So, APT is more helpful when it is used correctly, but CAPM is simpler for the armchair investor. 5. No attempt to find out all factors and different measures of relationships of price with different factors. In APT, the performance of the asset is taken to be independent from the market and its price is assumed to be driven by non-company and company specific factors. However, one drawback of APT is no attempt to find out these factors, and in fact one has to himself find out empirically different factors in case of every company that he is interested in finding the pricing of. More the number of factors identified, the more complicated the task becomes as one has to find different measures of relationships of price with different factors also.

Comparison Between CAPM and APT - Conclusion The basis of arbitrage pricing theory is the idea that the price of a security is driven by a number of factors. These can be divided into two groups: macro factors, and company specific factors. The difference between CAPM and arbitrage pricing theory is that CAPM has a single noncompany factor and a single beta, whereas arbitrage pricing theory separates out noncompany factors into as many as proves necessary. Each of these requires a separate beta. The beta of each factor is the sensitivity of the price of the security to that factor. Arbitrage pricing theory does not rely on measuring the performance of the market. Instead, APT directly relates the price of the security to the fundamental factors driving it. The problem with this is that the theory in itself provides no indication of what these factors are, so they need to be empirically determined. Obvious factors include economic growth and interest rates. For companies in some sectors other factors are obviously relevant as well such as consumer spending for retailers. Another difference is that in APT, the performance of the asset is taken to be independent from the market and its price is assumed to be driven by non company and company specific factors. The Arbitrage Pricing Theory or APT assumes that: 1. Only the systematic risk is relevant in determining expected returns (similar to CAPM). However, there may be several non-diversifiable risk factors (different from CAPM, since CAPM assumes only one risk factor) that are systematic or macroeconomic in nature and thus affect the returns of all stocks to some degree. 2. Firm specific risk, since it is easily diversified out of any well-diversified portfolio, is not relevant in determining the expected returns of securities (similar to CAPM). The APT model: 1. Does not require investors to hold any particular portfolio. There is no special role for any market portfolio. 2. Only systematic or non-diversifiable risk matters, but there may be several of these macroeconomic risk factors that affect the returns of well-diversified portfolios. It is up to the researcher to identify the risk factors. Such risk factors might happen to be unexpected changes in industrial production, inflation, real interest rates, etc. 3. Investors must agree on what the relevant risk factors are. There must be a linear relationship between the risk exposure or sensitivity (its loadings on the risk factors) and expected return of a security. The Capital Asset Pricing Model assumes any assets systematic or macroeconomic risk is captured by one risk factor the market risk factor. In a well-diversified portfolio, firm specific or diversifiable risk of the various stocks cancel out one another (they are random and independent among the firms) and is essentially eliminated in any well-diversified

portfolio. Adding one new stock to a well-diversified portfolio affects the risk of the portfolio depending upon the assets degree of market risk, as measured by its Beta. The assets firm specific risk wont contribute to portfolio risk. http://www.differencebetween.com/difference-between-capm-and-vs-apt/#ixzz1WxIliZAN http://www.differencebetween.com/difference-between-capm-and-vs-apt/#ixzz1WxHfkrsA Companies still might use CAPM for pricing their securities as it is less complex compared to the APT model. However, the other advantages of APT compensate for this drawback. To compare the APT with the CAPM model, we know that APT is the general form of CAPM. Also we know that the CAPM is a single factor model which works as measure of all risks known as beta but the APT takes more specific risks into account known as multiple risk factors model and has more powerful explanation ability. Thirdly, CAPM assumes that the market portfolio can be stated by Security Market Line (SML), but APT can also be used while market portfolio cannot be explained by the SML. Then, CAPM assumes the expectation of the rate of return is normally distributed while APT does not need this assumption. And, arbitrage pricing theory does not rely on measuring the performance of the market. Instead, APT directly relates the price of the security to the fundamental factors driving it. Another difference is that the CAPM assumes there exists a risk free rate in the market and investors can borrow money at this rate and the price of the security as the rate of market return. Lastly, there are some other assumptions for CAPM like zero transaction cost, zero taxes and so on. Although APT also assumes a zero transaction cost, what I want to say is that the APT has fewer assumptions, more accurate results and more powerful explanation ability to the model. For this model, we intend to use the APT model. The first reason is that the company feels the S&P 200 is a poor proxy for the market return, but we know that the CAPM model assumes any assets risk is captured by one risk factor the market risk factor and we use the price of the security to calculate the marker return and define beta but in APT, the performance of the asset is taken to be independent from the market and its price. Another reason we use the APT model is that the mining company faces multiple risk factors as mentioned above. Maybe it is not easy to take all risks into one single factor beta as some of them are company specific factors such as risks associated with the successful exploration and mining for these commodities and high cost of quality management, contractors and equipment for exploration, mining and corporate and administration functions. These risks affect the expected return of the mining company but may not affect not general companies. We know that CAPM only concerns one single factor, but APT may contain more risk factors including the firm specific risks. And, CAPM assumes a perfect market like no transaction cost, no taxes and so on, but for the mining company in the real world it is hard to achieve such a prefect market. Also, mining companies are supply-side driven thus, APT is more preferred as CAPM captures the demand side, which is market driven. So, obviously APT is better to estimate the cost of capital in this model.