Capital Asset Pricing Model in Finance and Accounting - Assignment Example

Finance and accounting [Insert al Affiliation] Introduction CAPM is one of the financial theories that describe the correlation that exists between expected return and risk and at the same time pricing the risk securities in the stock market for investment purposes. Considering the continual need for corporate managers to reduce risks without a significant decrease in returns, and the need to select the most profitable portfolios, the importance and correctness of CAPM is often questioned. This paper examines the importance and correctness of the model by drawing from various financial concepts and examples. CAPM-beta really provides the answer to the risk-return relationship? The conjecture behind the Capital Asset Pricing Model is that the money to be invested has two ideals: the risk and time values respectively. An investment of risky investment calls for compensation of the respective investor for the time and money devoted to the investment. Typically, the time value of money is symbolized by risk free (rf) in the formula. This is meant to reimburse an investor for investing money for some period of time. On the other hand, the risk measures the amount of reparation that is needed by an investor for taking an additional risk. It is computed by taking the beta that measures the return of the asset in the market over a period and market premium. Other assumptions of the model are: there is perfect competition in the market and, therefore, an individual cannot affect any price of an asset by selling or buying. All the investors have the same information regarding the availability of the securities prices and their respective risks involved. All investors in the market have an idea of making decisions based on variances and expected returns of the portfolios they desire to invest. It should be noted that beta indeed measures the amount of risk that is involved in investing in a particular stock in relation to the market risk. For example, if the market beta is 1 and an investor’s security has a beta of 2, it would be riskier than an investor’s security of 0.25. The theory postulate that expected return of a portfolio is equal to risk free security plus a risk premium then multiplied by systematic risk of the asset. Ra = rf + Beta (rm –rf). Where ra is the asset price rf is the risk-free rate of return, beta is the risk premium rm is the market rate of return. For example in the market, the risk free rate =4%, the beta of the stock = 2 and market return is 12% over time, the expected return of the stock will be 4%+2(12%-4%) =20%. The beta, therefore, provides an answer to the risk return relationship. Does CAPM provide a good account for pricing a firm’s debt or equity? CAPM model provides a vital account for pricing the debt and equity. This is because it takes into consideration factors like risk free rate that is the rate of return for investment that has a zero risk and firms risk premium which is the expected return on a risky that exceeds the return on a risk free asset (Shefrin, 2005). Cost of debt = risk-free rate + firm-specific risk premium.CAPM affirms that cost of equity of a firm capital is equal to the risk free rate added to specific risk premium (firm risk relative to market) multiply by the difference between risk free rate and market portfolio. ke,i = rf + i (rm – rf) However, a number of limitations connected to the CAPM have made the model to stand a chance for critics. The limitations of the model are as follows the model requires the assigning of the values for risk free rate of return, equity beta, market rate of return and risk premium rate that is somewhat cumbersome and unrealistic. Finding of the equity risk premium is difficult if not impossible. This is because the stock market provides a negative return in a shorter period instead of a positive return especially when falling share price outweighs dividend yields. This, therefore, calls for average expected rate of return to be used bringing in uncertainty in calculations. The value of beta is calculated and made available in all stock exchange markets. The problem that arises here is that beta value is never constant hence leading to uncertainty in calculating expected rate of return value. Finally, when using CAPM in investment appraisal is that it assumes single period times horizon is not the same as the multiple period time horizon investment appraisals while the variables are assumed to be constant in future, this is untrue in reality. Relevance of CAPM to corporate managers The model gives expected rate of return of each project that may be invested. It pinpoints that an investment that has a low rate of return offers better diversification while those with more market beta (more risk) require high expected rate of return for them to be desired as compared to projects that contribute less risk. In calculation of the cost of capital (expected rate of return) for a firm, CAPM needs three key inputs. That is the risk free rate of return rf, the expected rate of return on the overall market rm, and a firm’s beta in respect to the market (Pennacchi, 2008). The CAPM formula is given as Ra = rf + Beta (rm –rf) where Ra is cost of capital of the project. Given that the risk free rate is 2% and the cost of capital on the market (expected rate of return) is 5%, then CAPM states that Ra= 2% + (5%-2%).β = 2% + 3% = 5%. In this case, given a project with a beta of 0.5 will have a cost of capital 2%+5%.05 =4.5% while that project with a beta of 1% will have a cost of capital 2%+5%*1 = 7%. Therefore if a project with a beta of 1 cannot yield an expected rate of return of 7%, then the manager is advised not to take the project and instead they should return the respective money to their investors. This because the project will compound more risk to reward. The model takes into account systematic risks that affect all the firms and projects. This reflects a reality in the economic world in which managers have even diversified portfolios where unsystematic risks had been fundamentally eliminated. The corporate manager requires capital pricing model to get the denominator for calculating the Net Present Value, expected rate of return e(r) NPV = Co + + + …….. The combination of NPV formula and the CAPM hypothesize those cash flows that compare with market rate overall have less value to the investors and, therefore, calls for more cost of capital (expected rate of return (ε r)) Conclusion In lieu of the above elucidations, the CAPM is not wholly erroneous as it takes into account systematic risks that affect all the firms and projects. However, managers must exercise due diligence when using the model since the beta value obtained keeps on varying hence the risk-return association becomes unreliable. For investment purposes and pricing of equity and debt, corporate managers must reconsider their portfolio analysis criteria. References Pennacchi, G. G. (2008). Theory of asset pricing. Boston: Pearson/Addison-Wesley. Shefrin, H. (2005). A behavioral approach to asset pricing. Amsterdam: Elsevier Academic Press. Skiadas, C. (2009). Asset pricing theory. Princeton: Princeton University Press Read More