Capital Asset Pricing Model: Investment Valuation and Risk Assessment

This report provides an in-depth analysis of the Capital Asset Pricing Model (CAPM), a fundamental concept in financial management. It begins with an introduction to CAPM and its importance in determining investment worth by assessing the relationship between risk and return. The report emphasizes the significance of CAPM for both investors and businesses in estimating required rates of return and discount rates for investment appraisal. It explains the two types of risk (systematic and unsystematic), highlighting CAPM's focus on systematic risk through the use of beta. The report details the CAPM formula and its components (expected return, risk-free rate, beta, and market risk premium), and then it discusses the advantages of using CAPM, such as its consideration of systematic risk, its proven track record, its ability to establish a relationship between risk and return, and its superiority over other models like the dividend growth model and WACC in certain contexts. The report also notes the ease of calculation and the availability of the necessary data for CAPM, concluding that it is a valuable tool for both investors and business managers in making investment decisions and determining appropriate discount rates. Finally, it provides references to support its claims.

Capital Asset Pricing Model
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Introduction
The present paper is developed for analyzing and examining the significance of CAPM
model and is usefulness for determining the potential worth of an investment. The model of
CAPM is highly important in the field of financial management as it provides the investors the
impact on the returns of a profitability of stock in relation to the market volatility. In this
context, this paper is developed for providing an understanding of the importance of capital
asset pricing model and its contribution in carrying out risk assessment of a given portfolio of
securities.
Importance of CAPM (Capital Asset Pricing Model)
Investors and business firms face risk on every investment they made and calculating
the risk is the most important task that financial managers have to perform. There are mainly
two types of risk that business firms and investors face on their investment and these risks are
known as systematic risk and unsystematic risk. In this regards capital asset pricing model
proves to be best measure to estimate the required return on investments and also uses
systematic risk in the calculation so that best estimation of return can be defined (Damodaran,
2011).
The technique of Capital Asset Pricing Model (CAPM) is developed by William Sharpe
in mid 1960s for determination of the relation that exist between risk and return of an asset.
The model is founding extensive use by the investors in taking decisions in the context of
investing assets within a portfolio. CAPM represents the linier relationship between risk and
return that is required or expected on an investment. This investment can be made by the
investors in the company or investment made by the company in business operations. So it can
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be said that CAPM model can be used by both investors and company to estimate their
required rate of return on their investment made. CAPM formula only takes into account the
systematic risk in form of Beta and it totally ignore the unsystematic risk as it is not possible to
measure and calculate the unsystematic risk (Davies and Crawford, 2011).
Linear relationship of risk and return is shown as below (Formula of CAPM model):
E(r i ) = r f + b i (RP m )
(Moles and Kidwekk, 2011)
In the above formula, expected rate of return or required rate of required is denoted as
E(ri). Expected rate of return is also called as cost of equity as this rate of return is the cost that
company bear while employing equity capital within the business. rf is used denote the risk
free rate that company earn on securities that has no risk and there return is fixed such as
government bonds etc. bi is used denote the beta variable and it denotes the systematic risk that
one bear on investing in equity capital or risk bearing securities. RPm refers to as market risk
premium which calculated as market rate less risk free rate (Krantz, 2016).
In order to understand the essence of capital asset pricing model, there is need to
understand the advantages of using the CAPM as very important model to calculate the
expected rate of return. Some advantages of capital asset pricing model have been described
below:
 Capital asset pricing model take into account the systematic risk and do not focus on
unsystematic risk. Through use of diversified portfolio risk can be easily eliminated and
investors are only concerned about the systematic risk which is leftover after
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eliminating the unsystematic risk. So it can be said this model is very useful for the
investor who are risk averse and want to know the return they will earn through taking
into account the calculated risk (Schlichting, 2013).
 This model has been tested many times and has prove to very successful for measuring
the required rate of return by investors and management in company for making useful
decision. The required rate of return calculated by the CAPM model can be used by
management as the discount rate for investment appraisal techniques.
 CAPM model establish the relationship between the required return and systematic risk.
It means when beta or risk is zero, required rate of return will be equal to risk free rate
(No risk Situation) and when beta or risk is 1 than required rate will be equal to market
rate of return. It means when required rate of return changes with the change in beta
value.
 CAPM is superior method than the dividend growth model to estimate cost of equity as
it takes into account the systematic level of company that it bear relative to the stock
market as a whole (Zimmerman and Yahya-Zadeh, 2011).
 CAPM is superior to the WACC while calculating the discount rates for the investment
appraisal projects. WACC takes into cost of all the capital and does not focus on the
market risk but CAPM focus on the market risk and provides proper discount rate so
that management can make right investment decision.
Essence of CAPM not only lies within its advantages but it is very easy to calculate and
easy to use. The value used in estimating the required rate to return is mostly readily available
for the investors and they can make use of it easily in the formula of CAPM. This model also
assumes that investors hold the diversified portfolio and only concerned about the systematic
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risk and no other risk. This model is also very effective when business is looking to invest in
other business and financing & business mix differ from the current business than WACC
cannot be applied but CAPM model can be applied. In short it can be said that CAPM is best
model for investors as well as for the business managers for determining the return that
investors will earn on their investment and for businesses in estimating the discount rate used
for capital investment appraisal decisions (Arnold, 2013).
Conclusion
The overall information on CAPM model guides that it has critical role in measuring
the required rate of return on investment. It takes into account three main factors while
calculating the required rate of return and these factors are beta (systematic risk), risk free
return and market return. The required rate of return guides that how much return will investors
earn over the risk free rate by taking into accounting the systematic risk or market risk (beta).
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References
Arnold, G., 2013. Corporate financial management. USA: Pearson Higher Ed.
Brigham, F., and Michael C. 2013. Financial management: Theory & practice. Canada:
Cengage Learning.
Damodaran, A, 2011. Applied corporate finance. USA: John Wiley & sons.
Davies, T. and Crawford, I., 2011. Business accounting and finance. USA: Pearson.
Krantz, M. 2016. Fundamental Analysis for Dummies. USA: John Wiley & Sons.
Moles, P. and Kidwekk, D. 2011. Corporate finance. USA: John Wiley &sons.
Schlichting, T. 2013. Fundamental Analysis, Behavioral Finance and Technical Analysis on
the Stock Market. Australia: GRIN Verlag.
Zimmerman, J.L. and Yahya-Zadeh, M., 2011. Accounting for decision making and
control. Issues in Accounting Education, 26(1), pp.258-259.
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