Capital Asset Pricing Model (CAPM): Pros and Cons.

CAPM defines the relationship between risk and return. The premise of the model is that the expected investment return varies in direct proportion to its risk, i.e., the riskier the investment - the higher the return you should expect. Shows:

•how much risk you are taking when investing in an instrument? •whether the instrument is rightly priced
•whether you are getting sufficient return for the risk you are taking

CAPM calculates the risk-adjusted discount rate with the risk-free rate, the market risk premium, and beta (mathematical formula):

Return (R) = Rf + beta x (Rm - Rf)

Rf is the rate of risk-free investments
Beta - the risk of loss associated with your investments.
Rm is the expected market return.
(Rm-Rf) – market risk premium
beta x (Rm - Rf) – risk premium of specific company

Investments are good if the expected return from the investment equals/exceeds required return.

Market Risk Premium [Rm-Rf]
The additional return over the risk-free rate needed to compensate investors for assuming an average amount of risk Its size depends on the perceived risk of the overall stock market and investors’ degree of risk aversion Varies across time. Usually ranged between 4-8%

BETA in CAPM measures a stock’s degree of systematic or market risk. It can also be thought of as the stock’s contribution to the risk of a well-diversified portfolio •beta = 1 the stock has average market risk. The stock generally tends to go up (down) by the same percentage amount as the market •beta = 1.5 the stock generally tends to go up (down) by 50% (1.5x) more than the market •beta = 0.5 the stock generally tends to go up (down) by half as much as the market •beta = 0 the stock has no correlation with movements in the overall stock market. All of the firm's risk would actually be firm-specific risk •beta < 0 the stock generlly tends to move in a direction opposite that of market (very rare)...

...CAPM: THEORY, ADVANTAGES, AND DISADVANTAGES
THE CAPITALASSETPRICINGMODEL RELEVANT TO ACCA QUALIFICATION PAPER F9
Section F of the Study Guide for Paper F9 contains several references to the capitalassetpricingmodel (CAPM). This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January 2008 issue of student accountant introduced the CAPM and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula. The second article, published in the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use in investment appraisal.
CAPM FORMULA The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the CAPM formula, which is given in the Paper F9 Formulae Sheet: E(ri) = Rf + βi(E(rm) - Rf) E(ri) = return required on financial asset i Rf = risk-free rate of return βi = beta value for financial asset i E(rm) = average return on the capital market The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific...

...CapitalAssetPricingModelCapitalAssetPricingModel (CAPM)
Capital market theory extends portfolio theory and develops a model for pricing all risky assets. It is an equation that quantifies security risk and defines a risk/return relationship
Capitalassetpricingmodel (CAPM) will allow you to determine the required rate of return for any risky asset
Implications of the CAPM:
CAPM indicates what should be the expected or required rates of return on risky assets
This helps to value an asset by providing an appropriate discount rate to use in dividend valuation models
You can compare an estimated rate of return to the required rate of return implied by CAPM - over/under valued ?
Assumptions of the CAPM
1. All investors are Markowitz efficient investors who want to target points on the efficient frontier.
2. Investors can borrow or lend any amount of money at the risk-free rate of return
3. All investors have homogeneous expectations;
4. All investors have the same one-period time horizon such as one-month, six months, or one year
5. All investments are infinitely divisible, which means that it is possible to buy or sell fractional shares of any asset...

...of Capital at Ameritrade
1-a How can the CAPM be used to estimate the cost of capital for a real business investment decision?
CAPM results can be compared to the best expected rate of return that investor can possibly earn in other investments with similar risks, which is the cost of capital. Under the CAPM, the market portfolio is a well-diversified, efficient portfolio representing the non-diversifiable risk in the economy. Therefore, investments have similar risk if they have the same sensitivity to market risk, as measured by their beta with the market portfolio.
So, the cost of capital of any investment opportunity equals the expected return of available investments with the same beta. This estimate is provided by the Security Market Line equation of the CAPM with states that, given the beta, of the investment opportunity, its cost of capital is
Ri=rf+Bi*(E[Rmkt]-rf)
In other words, investors will require a risk premium comparable to what they would earn taking the same market risk through an investment in the market portfolio.
1-b What type of cash flows and discount rate you are evaluating in this project? Is there any financial effect (i.e. leverage) involved? Why, or why not?
We use free cash flows and the asset cost of capital as discount rate in evaluating this project. There is financial effect involved, since the Ameritrade have both debts and...

...CAPITALASSETPRICINGMODEL
The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus a risk [pic]premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas).
Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM example: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)).
THE CAPM MODEL
A model that describes the relationship between risk and expected return and that is used in the pricing of risky securities.
[pic]
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 risk-free (rf) rate in the [pic]formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs 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...

...Introduction
Capitalassetpricing has always been an active area in the finance literature. CapitalAssetPricingModel (CAPM) is one of the economic models used to determine the market price for risk and the appropriate measure of risk for a single asset. The CAPM shows that the equilibrium rates of return on all risky assets are function of their covariance with the market portfolio. This theory helps us understand why expected returns change through time. Furthermore, this model is developed in a hypothetical world with many assumptions.
The Sharp-Lintner-Black CAPM states that the expected return of any capitalasset is proportional to its systematic risk measured by the beta. (Iqbal and Brooks, 2007). Based on some simplifying assumptions the CAPM is expressed as a linear function of a risk free rate, beta and the expected risk premium. An important quantity required for decisions on evaluating public and private funded projects is an appropriate cost of capital. This discount rate is often estimated by a model of expected return. The CAPM has been extensively employed for estimating cost of capital and evaluating the performance of managed funds.
Various studies had been performed by various researchers on the capital...

...RISK & CAPITALASSETPRICINGMODEL | |
|Every financial investment contains some | |To see how the risk matrix (see below) described in this tutorial is used, please |
|level of financial risk. This risk is | |take a look at FinanceIsland's ROI analysis tool. You can try it out
|usually expressed through the discount rate | |by subscribing for a free trial.
|used in the financial analysis. Since the | |
|risk varies from investment to investment, | |[pic]
|the discount rate needs to vary as well. | |
| | |
|FinanceIsland's ROI analysis tool with Monte| |
|Carlo simulation enhances your typical net | |
|present value (NPV) analysis not only by | |
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...also found on the balance sheet. The value was $3,494.5 million. Therefore, Joanna found Nike’s debt plus equity to be $4,791.4 million. Dividing the values for debt and equity each by $4,791.4 million gave Joanna the weights to be used in the WACC formula. Debt was weighted as 27% and equity as 73%.
Joanna then proceeded to calculate Nike’s costs of debt and equity. She found Nike’s cost of debt by dividing total interest expense, which was found on the income statement, by her previous calculation for debt. Nike’s total interest expense was $58.7 million, so their cost of debt was found to be 4.3%. Joanna used a tax rate of 38% in her calculations, making Nike’s cost of debt after tax to be 2.7%. Joanna decided to use the CAPM model in her calculation of Nike’s cost of equity. She used the risk-free rate of 5.74% on a 20-year Treasury bond, the geometric mean for market risk premium from 1929 to 1999 which was 5.9%, and Nike’s average beta from 1996 to 2001, which was 0.80 to make her calculations. Using these values, she obtained a cost of equity of 10.5%. Joanna then took the weights and costs of debt and equity that she found and calculated Nike’s WACC to be 8.4%.
Joanna made several errors in her calculation of Nike’s WACC. To begin, she used book values when finding Nike’s debt and equity rather than market values.
If markets are efficient, market values will equal present value of cash flows. Book values, on the other hand, represent...

...A Chartered Financial Analyst, Jeffrey Bruner, uses the CapitalAssetPricingModel (CAPM) to help identify mispriced securities. However, a consultant suggests Bruner to use Arbitrage Pricing Theory (APT) instead. As the following, it will mention the role of CAPM in the modern portfolio management; to clarify the APT faction and explain the reasons why should Bruner use APT to help identify mispriced securities.
In modern portfolio management, the role of CapitalAssetPricingModel (CAPM) is a model that attempts to describe the relationship between the risk and the expected return on an investment and that is used in the pricing of risky securities. The assumption behind the CAPM is that there is only one risk-free rate in the model, investors can borrow and lend unlimited amounts under the risk rate of interest; the perfect information is freely available to all investors who, as a result, have the same expectations; that all investors are risk averse, rational and desire to maximise their own utility; and the capital market is characterised by perfect competition, there are broadly diversified across a range of investments and the investors will only require a return for the systematic risk of their portfolio, since unsystematic risk has been removed and can ignored. It also assumes...