Capital Asset Pricing Model: Assumptions, Criticisms, and Importance

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Strategic Finance

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Table of Contents
Introduction to CAPM.....................................................................................................................3
Criticisms of Model.........................................................................................................................4
Assumption of true market portfolio...........................................................................................4
Assumption of Beta.....................................................................................................................4
Argument for future cash flows...................................................................................................5
Concern in relation to risk free borrowing assumption...............................................................5
Alternative model............................................................................................................................6
Importance of CAPM......................................................................................................................6
Advantages of CAPM......................................................................................................................7
Conclusion.......................................................................................................................................9
References......................................................................................................................................11

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Introduction to CAPM
Capital asset pricing model is the technique which is used by the businesses for the
ascertainment of the cost of capital for their entity. This is very useful and so it is necessary that
all the information in this relationship shall be identified. The essay will be representing the
manner in which this is useful with the undertaken assumptions also. All of the aspects are
covered and in that the assumptions which are involved will also be undertaken. This is the
technique which will be of great use for the business as will also be helpful in the making of
various decisions which are relevant for the business (Chong, Jin and Phillips, 2014). This is the
model in which the risk and return both are taken into account and by that the relation among
them is identified. There will be consideration of all the elements which are involved in relation
to them. By that, the calculation of the rate of capital is made which is attained after involving all
the aspects and so is the accurate one. In this, the risk premium and beta both are taken into
account so that all the uncertainties involved are determined and involved in advance. There is
the involvement of the systematic risk in this and due to that, it is widely used (Fama and French,
2012). By the help of this, the impact of the diversification and other elements on the returns is
eliminated. There is the sensitivity which is involved in relation to the return which is obtained
on the stock in comparison to the market portfolio and for that the beta is taken into
consideration. It is taken into consideration in this model that the beta will be the main factor in
the determination of the cost of equity capital for investors. There is the formula which is used
for the calculation of the same in which the risk-free rate, risk premium, and beta are taken into
use. The beta will be multiplied with the risk premium and then the outcome will be added to the
risk-free rate. The result which will be attained is identified as the cost of equity capital.

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Criticisms of Model
The relationship which is present among all of them is identified and understood in an effective
manner by the help of this model. There are several criticisms which have been faced by the
CAPM model in relation to its validity (Zabarankin, Pavlikov, and Uryasev, 2014). The making
of the capital asset pricing model is dependent on certain assumptions which were used in its
formulation. This is one of the best models and provides accurate results and then also faces the
issues. It has been argued by many people that the model is not appropriate due to a large
number of assumptions which are made under this.
Assumption of true market portfolio
In this model, it is assumed that there is a true market portfolio and according to Richard roll,
this is not possible as there is no such portfolio (Roll, 1977). Due to this, the model is considered
to be inaccurate and inadequate by him. It has been provided by him that a portfolio will be
considered to be diversified only if there has been consideration of all the investments which
have been made in all the assets and that too covered in the whole world. In accordance with this,
the method of incorporating the inefficient market proxies is inefficient which is used in CAPM
as there is not the involvement of all the financial assets into this. Therefore the use of mean-
variance in this is not correct and by that, the perfect employee will be represented as less
efficient.
Assumption of Beta
Another argument which was posted against the capital asset pricing model is that the capital
structure which is there in the company changes from time to time but the beta value which is