## What is CAPM?

As the name itself suggest, the Capital Asset Pricing Model (CAPM) is used for pricing the security with a given risk. This model describes the relationship between the expected return & risk in investing security. This article describes the advantages & disadvantages of CAPM.

CAPM shows that the expected return on a security is equal to a risk-free return plus a risk premium, which is based on the beta of the security. Assumptions of CAPM are the heart of the model.

Table of Contents

- What is CAPM?
- Formula of CAPM
- Advantages of CAPM
- Eliminates Unsystematic Risk
- Systematic Risk
- Investment Appraisal
- Ease of Use

- Disadvantages of CAPM
- Too Many Assumptions
- Assigning Values to CAPM Variables
- Ability to Borrow at Risk-free Rate
- Determination of Project Proxy Beta

- Conclusion

## Formula of CAPM

Ra = Rf + Ba (Rm-Rf)

Where,

Ra = Expected return on a security

Rf = Risk-free rate

Rm = Expected return of the market

Ba = Beta of the security

## Advantages of CAPM

### Eliminates Unsystematic Risk

CAPM assumes that the investor holds a diversified portfolio, similar to a market portfolio. A diversified portfolio eliminates unsystematic (specific) risk.

### Systematic Risk

CAPM considers systematic risk, which is left out of other return models, such as the dividend discount model. Systematic risk, also known as market risk, is an important variable because it is unforeseen and often cannot be mitigated as it is not fully expected.

### Investment Appraisal

An investor can also use CAPM for investment appraisal compared to other rates; it offers a superior discount rate. This model clearly links required return & systematic risk.

### Ease of Use

CAPM is a simplistic calculation that can be easily stress-tested to derive a range of possible outcomes. Those outcomes provide confidence around the required rate of returns.

## Disadvantages of CAPM

### Too Many Assumptions

The CAPM model is based on too many assumptions, which many criticize as unrealistic. Therefore, it may not provide the correct results.

### Assigning Values to CAPM Variables

Risk-free Rate (Rf): The commonly accepted rate used as the Rf is the yield on short-term government securities. The problem with using this input is that the yield changes daily, creating volatility.

Return on the market (Rm): The return on a stock market is the sum of the average capital gain and the average dividend yield. The market return can be negative in a short-term market. As a result, the long-term market return is utilized. The other major drawback is that these returns are backward-looking & not futuristic.

Beta (B): Beta values are regularly published on all stock exchanges regularly for all listed companies. The issue here is that uncertainty arises in the value of the expected return because the value of beta is not constant but changes over time.

### Ability to Borrow at Risk-free Rate

There are four major assumptions of CAPM. One of the assumptions is that investors can borrow & lend the funds at a risk-free rate. This assumption is unrealistic for the real world. Individual investors are unable to borrow or lend at the same return as the US government.

Therefore expected return calculated by the CAPM model may not be correct in this situation.

### Determination of Project Proxy Beta

The problem may arise in using the CAPM to calculate a project-specific discount rate. Generally, equity beta & portfolio/investment beta are different. Therefore, the company needs to find a proxy beta for the project.

However, finding accurate proxy beta might be difficult and can affect the reliability of the outcome.

## Conclusion

Research has shown the CAPM stands up well to criticism, although attacks against it have been increasing in recent years. Until something better presents itself, the CAPM remains a very useful item in the financial management toolkit.

## RELATED POSTS

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## Sanjay Bulaki Borad

Sanjay Borad is the founder & CEO of eFinanceManagement. He is passionate about keeping and making things simple and easy. Running this blog since 2009 and trying to explain "Financial Management Concepts in Layman's Terms".

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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 Formulae Sheet:. Investors hold diversified portfolios This assumption means that investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been diversified and can be ignored.. Investors can borrow and lend at the risk-free rate of return This is an assumption made by portfolio theory, from which the CAPM was developed, and provides a minimum level of return required by investors.. While the assumptions made by the CAPM allow it to focus on the relationship between return and systematic risk, the idealised world created by the assumptions is not the same as the real world in which investment decisions are made by companies and individuals.. Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised world rather than the real-world, there is a strong possibility, in the real world, of a linear relationship between required return and systematic risk.. the investment project is small compared to the investing organisation the business activities of the investment project are similar to the business activities currently undertaken by the investing organisation the financing mix used to undertake the investment project is similar to the current financing mix (or capital structure) of the investing company existing finance providers of the investing company do not change their required rates of return as a result of the investment project being undertaken.. These assumptions are essentially saying that WACC can be used as the discount rate provided that the investment project does not change either the business risk or the financial risk of the investing organisation.. If the business risk of the investment project is different to that of the investing organisation, the CAPM can be used to calculate a project-specific discount rate.. Project A would be rejected if WACC is used as the discount rate, because the internal rate of return (IRR) of the project is less than the WACC.. This investment decision is also incorrect, however, since project B would be rejected if using a CAPM-derived project-specific discount rate, because the project IRR offers insufficient compensation for its level of systematic risk (Watson and Head, pp.291-2).. Assigning values to CAPM variables To use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta.. Using the CAPM in investment appraisal Problems can arise in using the CAPM to calculate a project-specific discount rate.. The proxy beta for a proposed investment project must be disentangled from the company’s equity beta.. One way to do this is to treat the equity beta as a portfolio beta (βp), an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity.. Another disadvantage in using the CAPM in investment appraisal is that the assumption of a single-period time horizon is at odds with the multi-period nature of investment appraisal.

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The Capital Assets Pricing Model is a model used b y investors to find the relationship between their required rate of return from an investment and the systematic risk of the investment.. This makes the Capital Asset Pricing Model a superior tool to these when it comes to evaluating investments with risks involved.. In order to calculate the rate of return of an investment using the Capital Asset Pricing Model, it is important for investors to determine the risk-free rate of return.. The risk-free rate of return is a theoretical rate of return of an investment with no risk.. Investors need to average out the changes over a period of time to get an average value for the risk-free rate of return which can be difficult.. However, if an investor is considering investing in a non-listed company, they have to calculate the beta coefficient themselves.. In addition, like the risk-free rate of return, the beta coefficients of an investment can also change over time.. Furthermore, as the beta coefficient is the measure of the systematic risk of a company for a particular market, it is difficult to calculate for companies that operate in different markets or segments.. This even makes the beta coefficient incomparable with other companies.. The Capital Asset Pricing Model considers the return on the market when calculating the rate of return of an investment.. The Capital Asset Pricing Model assumes investors can borrow and lend money without any limitations at a risk-free rate.. The Capital Asset Pricing Model assumes a perfect market when calculating the rate of return of an investment.. The Capital Asset Pricing Model also assumes there are no transaction fees involved when investing.. These limitations may arise when calculating the rate of return using the model using different variables such as risk-free rate of return, beta coefficient or the average return on the market.. Additionally, these limitations may also arise from the assumptions this model makes.

### CAPM: theory, advantages, and disadvantages ›

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### What Is The Capital Asset Pricing Model? ›

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### Advantages And The Drawbacks Of The Capm Model Finance Essay - Free Essay Example by Essaylead ›

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archival boxes for photos Oct 11, 2021 · The Capital Asset Pricing Model ( CAPM ) is a financial model that relates the risks and returns of assets.. PMI is known globally for its project management literature and certifications.. Advantagesof the CAPM The CAPM has several advantages over other methods of calculating required return, explaining why it has been popular for more than 40 years: It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.. Definition: Capital asset pricing model ( CAPM ) is a tool used by investors, financial analysts and economists to study the relationship between the expected return from the investment and the systematic risk involved (measured in terms of Beta coefficient), by taking into consideration the expected overall market return and the risk-free rate of interest.. The capital asset pricing model ( CAPM ) demonstrates that the market portfolio is essentially the efficient frontier.. CAP model requires information on risk-free return rate, the value of Beta factor for a given firm (which is used to measure.

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