Finance Assignment Paper on The Capital Asset Pricing Model

The Capital Asset Pricing Model (CAPM)

CAPM is a tool used by investors to appraise securities risk and the expected return over time. CAPM measures risk in two perspectives, unsystematic risk that is induced by executive factors and the systematic, which varies along with economic trends (Fama & French, 2004). As such, the capital asset pricing model appreciates stock risk in relation to the market. The risk-free rate is considered the required rate on a riskless asset, for instance, the American treasury bills. In CAPM, beta represents a stock risk factor in proportion to market variations. For instance, an asset beta of 1.2 is quite riskier if the market factor is 0.8 (Bellalah & Wu, 2009). The required return on any risky asset ought to surpass the return on treasury bills. Thus, securities with a high systematic risk promise higher average long-term returns.

The CAPM assists in calculating the weighted average costs of capital (WACC) through the computation of the cost of equity estimated using a levered Beta factor. The required rate of return on equity computed using CAPM is multiplied by the equity-debt ratio and then added to the weighted cost of debt. Financial managers encounter beta-forecasting problems while using the CAPM, ra = rrf + Ba (rm-rrf), due to unexpected individual stock movements (Alves, 2013). For instance, managers may underestimate the risk factor, thereby giving an incorrect asset return value. In addition, managers may lack information pertaining a company’s market value. The CAPM is a linear expression that eliminates unsystematic risk, hence simple and reasonable. Thus, the statistical methods applied in the CAPM are compelling and reliable. However, the model runs on assumptions that may not match the real conditions, thereby negating the ultimate desire to eliminate risks.

References

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Alves, P. (2013). The Fama French Model or the capital asset pricing model: international evidence. The International Journal of Business and Finance Research,7(2),79-89.

Bellalah, M., & Wu, Z. (2009). An Intertemporal Capital Asset Pricing Model under Incomplete Information. International Journal of Business, 14(1), 47.

Fama, E. F., & French, K. R. (2004). The capital asset pricing model: theory and evidence. Journal of Economic Perspectives, 25-46.