The Capital Asset Pricing Model

Introduction

Back in 1960s, William Sharpe and John Lintner developed the Capital Asset Pricing Model (CAPM) that offers pleasing predictions on risk and the relation between expected return and risk. For the past decades, the capital asset pricing model has been widely utilized in applications. Applications such as estimating the cost of equity capital for companies as well as evaluating the performance of the portfolios (Fama and French, 2004). The idea behind CAPM offers a methodology for quantifying risk and converting that risk into the approximations of expected return on equity. It portrays how the markets price securities and thus conclude expected return on capital investments (Berkman, 2012). Despite the fact that it is by far the

It is essential for all management to use capital budgeting techniques to decide which projects will make the highest return. Subsequently, if there are no capitalist restrictions or any other restrictions, shareholder value is then extended by selecting the positive Net Present Value (NPV) projects (Bennouna, Meredith and Marchant, 2010). As mentioned, the CAPM is used to estimate the cost of equity for project selection, and cost of equity is basically a key factor of stock valuation. The CAPM is a theoretical representation of the behavior of the financial market and it can be employed to estimate the company’s cost of equity capital. It is a rate of return that convinces investors make an investment, especially long-term investment decisions (Da, Guo and Jagannathan, 2012). Moreover, since the cost of equity does involve the expectations of the market, it generally will be harder to measure. The other widely used method to calculate the cost of equity is by using the Gordon’s Growth Model (also known as the Dividend Discount Model). It calculates the fundamental value of today’s stock, based on the stock’s expected future dividends (Farrell, 1985). The dividend discount model focuses strictly at the future dividends as the sum of cash flows discounted by investors required rate of return and expected growth of dividend. Not

The estimation of expected return and the cost of equity for stocks in vital to many financial decisions. For example, portfolio management, performance evaluation and capital budgeting. Even after several decades, the CAPM is still widely used and popular despite being based on very strong assumptions. The assumptions were few yet powerful enough to spark debates throughout the years. In this essay, we have listed four common assumptions of the CAPM and the critiques of each assumption. In response to the assumptions, regardless the CAPM still managed to stand strong on its believe and offers simple yet pleasing results. As the model is simpler to use, it is great for people who does not have a strong finance background to get the same results. However, financial decision makers should not rely just on the CAPM as a specific process to estimate the cost of equity capital, rather, use the model in conjunction with other approaches for better and more accurate results. Lastly, an alternative to the CAPM is the Fama and French three-factor model. As it is an expanded version of the CAPM, it provides users a different approach to measure performance and predicting return. The three-factor model adjusts for the outperformance tendency which is thought to be a better evaluation tool for managing performance. To sum it off, every model has its own pros and cons, there are