The principal advantage of CAPM is the nature of the estimated cost of equity that it can generate. It is a better return model as it considers systematic risk, reflecting a reality, which is usually ignored by other models, to calculate the cost of equity. It helps investors ascertain the amount of risk premium required as a compensation for the extra risk that they take. However, this does not hold true in the real world.ĬAPM is one of the widely used model for calculating the risk and returns associated with investing in a stock. It suggests that investors are only concerned with the wealth their portfolio produces at the end of the current period. The model focuses on single period time horizon. However, other factors such as relative sensitivity to inflation, dividend payout and others may also impact a security’s return. Thus, these may not be reflective of the true risk involved and therefore are not good estimates of future risk.ĬAPM assumes that a security’s required rate of return is based only on one factor, i.e., systematic risk. The Beta values are unstable and vary from time to time. However, this rate keeps on changing on regular basis with the changing economic circumstances. The yield on GOI bonds is used as a substitute for the risk free rate. Thus, the minimum required rate of return by an investor might be more than what the model incorporates. Investors are unable to borrow or lend at the GOI bond rate. One of the assumptions used in CAPM is that investors can borrow as well as lend funds at a risk free rate, which is actually unreal. Thus, CAPM is superior to other return models in providing discount rate to be used in investment appraisal. When exploring business opportunities, if the business mix and financing differ from the current business, then other return models, especially WACC, cannot be used but CAPM can easily be used. This is generally left out by other return models, like the dividend discount model (DDM). It is comparatively much better method of calculating cost of equity as it takes into account a company’s level of systematic risk relative to the stock market as a whole. It is vital in calculating the Weighted Average Cost of Capital (WACC), as it calculates cost of equity, a major component of WACC. Moreover, it equates the relationship between the rate of return and risk in Theoretical form, so it can be useful in empirical researches and testing. Re = Expected rate of return or Cost of EquityĬapital asset pricing model is a widely used, return model that is simple and easy to calculate. The CAPM formula represents the linear relationship between the required rate of return on an investment and its systematic risk. It is widely used by corporate and financial managers in their attempt to calculate the realistic and useful costs of equity.ĬAPM can be used to identify risk premiums, examine corporate financing decisions, spot undervalued investment opportunities and compare companies across different sectors. It explains the relationship between the expected return on assets, particularly stocks where systematic risk is involved. Thus, the concept of Beta (β) is central to this model, as it measures the systematic risk of a stock. The model assumes that investors hold fully diversified portfolio and thus want a return that compensates them for bearing the systematic risk, rather than the total risk. So, capital asset pricing model (CAPM) evolved as a way to measure the undiversifiable or systematic risk of a stock or portfolio of stocks. Therefore, when calculating the expected or appropriate return, the systematic risk is what an investor should focus upon. Thus, Total Risk = Systematic risk + Unsystematic risk This risk can be reduced through diversification. Unsystematic risk – This is a risk that is inherent to a specific company or industry. This type of risk is both unpredictable and non-diversifiable in nature. Systematic risk – This is a risk that is inherent to the entire market or a market segment. The model was developed by Nobel laureate William Sharpe in 1970 and states that every individual investment comprises of two kinds of risk:.This is well explained by the Capital Asset Pricing Model (CAPM)that provides a methodology to quantify risk and translate that into expected return on equity. Problems with Capital Asset Pricing Model Table of ContentsĪdvantages of Capital Asset Pricing Model Moreover, equity investments demand higher returns. So, understanding the risk-return trade-off is of utmost importance for any investor while making an equity investment. Investment in the stock market is comparatively riskier and no matter how much an investor diversifies his investments, some level of risk will always be there. So, it can be understood that the concept of risk and return go hand in hand.
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