Capital Asset Pricing Model (CAPM) is a theoretical framework that illustrates the association between risks and the expected rate of return of an asset. CAPM is used in the valuation of the risk. The principle idea of CAPM is that you should be compensated for the time value of money and the risk. Though CAPM is very important in calculating investment risk and the return on investment that you should expect, it has some drawbacks.
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In calculating discounts for investment appraisal using the CAPM formula, you will realise that CAPM has a linear correlation with the return you need for investment. When you express the linear correlation in a graph, you get a security market line that describes the difference between the market risk and the expected market rate of return. This is an easy, simple approach that eliminates risk specific to your company, also referred to as unsystematic risk. Hence, CAPM assists you in developing a theoretical relationship between systematic risk and required return.
Preferred Decision Making Tool
CAPM can to help you make the best decision when compared to the other methods. For instance, the weighted average cost of capital, or WACC, which is used to appraise investments, is inconclusive. You may reject a worthwhile project because its internal rate of return, or IRR, is less than that of the WACC, since WACC assumes that the investment project does not affect the financial and business risks. However, you can depend on CAPM because it gives project IRR that is higher than the security market line and a return that is necessary to offset systematic risk. Therefore, it is clearly a superior approach to the WACC in calculating discount rates for use in investment appraisal. In addition, CAPM method is preferred for calculating the cost of equity than the Dividend Growth Model (DGM) since it takes into consideration the business level of systematic risk relative to the stock market as a whole.
CAPM is criticised as being unrealistic because of its many assumptions. CAPM assumes that there is a perfect capital market, you can borrow and lend money at the risk free rate of return, investors hold diversified portfolios and there is a single transaction perspective. However most of these assumptions do not represent real conditions. It is impossible to have a perfect market and assets that are priced correctly. Furthermore, you can not borrow or lend money at the risk-free rate, so the curve of a security market line is most likely to be shallower in reality.
In actual world markets, discount allowances and investment appraisals are estimated based on a long-term time frame. CAPM calculations, on the other hand, are projected on a single-period time frame, usually an investing time period of one year; this time frame is considered to be constant for a very long period, but in ideal market this is not the case.
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