Importance of CAPM in Strategic Finance

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Strategic Finance

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Table of Contents
Introduction......................................................................................................................................3
Importance of CAPM......................................................................................................................3
Assumptions involved in the model................................................................................................4
Diversification assumption..........................................................................................................4
True portfolio assumption............................................................................................................4
Risk free rate investment assumption..........................................................................................6
Criticism of CAPM..........................................................................................................................6
Alternative models...........................................................................................................................7
Benefits of CAPM...........................................................................................................................7
Conclusion.......................................................................................................................................8
References........................................................................................................................................9

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Introduction
In the business, there are various investments which are made and it is required that proper
analysis shall be made in respect of them. There is the return which is expected from all the
investments and also there is a certain amount of the risk which is involved in all the projects.
Due to that, there is a technique which is used and is identified as the capital asset pricing model.
In that, the relationship that exists among the risk and the expected return is taken into
consideration. All of the aspects in relation to this are discussed in the below presented essay.
Importance of CAPM
There is the determination of the cost of capital by the help of this and that is useful in making
any decision in this respect (Zabarankin, Pavlikov, and Uryasev, 2014). There is the inclusion of
beta in the model which covers the risk that is involved in the business. There is the formula
which is used for the making of the calculation and in that risk premium and the risk-free rate is
also taken into use. There is the risk premium and it is multiplied with the available beta for that
security and then the risk-free rate is added to it. The result which is obtained is used for various
purposes and by that the use of the capital asset pricing model is also identified. The model is
used by the company for several reasons and of which the most important is for the calculation
of the cost of equity (Barberis et al., 2015). This is used to take the decision and also will be used
in the ascertainment of the intrinsic value of the security as the rate which is used in the model is
the cost of equity only. The decision-making process is further enhanced by the use of the same.
The rate which is derived from the calculation of the cost of equity will be used as the discount
factor in the calculation of net present value. The capital budgeting decision will be taken with
the help of this.