Critical Analysis of CAPM's Utility in Strategic Finance - MN3365

This essay provides a detailed analysis of the Capital Asset Pricing Model (CAPM), examining its development, assumptions, advantages, disadvantages, and limitations. It discusses the model's practical applications in investment management and corporate finance, including security comparison, asset pricing, and intrinsic value assessment. The essay also addresses the criticisms of CAPM, particularly concerning its unrealistic assumptions and the challenges in applying it to real-world market scenarios. It concludes that while CAPM has limitations, it remains a valuable tool for understanding asset pricing and expected returns, especially when complemented by econometric methods and advanced risk-free rate replacements. The principles of modern portfolio theory used by this model enable investors to calculate expected reward and risk.

Running head: STRATEGIC FINANCE
Strategic Finance
Name of the Student:
Name of the University:
Author’s Note:

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Table of Contents
INTRODUCTION...........................................................................................................................2
DEVELOPMENT OF CAPM MODEL..........................................................................................2
ASSUMPTIONS OF CAPM MODEL............................................................................................3
ADVANTAGES OF THE CAPM...................................................................................................5
DISADVANTAGES OF THE CAPM............................................................................................5
LIMITATIONS OF CAPM MODEL..............................................................................................6
CONCLUSION................................................................................................................................6
REFERENCES................................................................................................................................8

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INTRODUCTION
Equity markets are considered to be high risk markets which are managed by the activities of the
investors and fund managers. In this type of market there are possibilities of high profits and risk
of incurring heavy losses. The fund managers and investors take aid of various tools for
calculating the risk and return of their investments.
The finance industry makes extensive use of Capital Asset Pricing Model. The model was
founded by Harry Markowitz in the year 1952. This framework was further developed by
economist Jack Treynor, John Lintner, Jan Mossin and William Sharpe. This is a mathematical
model which helps in describing the relationship between the investors expected returns and the
risk associated with capital asset. Securities, stocks and bonds are included in the capital stock.
As per CAPM theory, the expected return related to specific portfolio or security is same as the
rate related to security without risk and risk premium. It is structured for calculating the price of
high risk securities. Investment should not be done if the portfolio or stock does not meet or
surpass the expected return (Bai et al., 2015).
DEVELOPMENT OF CAPM MODEL
CAPM model has been based on the theory of portfolio management which has been created by
Harry Markowitz, as per Harry portfolio should have expected rate and returns. The expected
returns relates to the expected return on securities while the risk relates to the risk associated
with individual components. If the relevancy of return and risk associated to specific conditions
are considered it can be seen that more returns are gained on higher risk while less returns are
earned on lower risks. Mean variable analysis is the process in which the multidimensional and
complex problem of portfolio choice related to large quantity of diverse assets is reduced to a
two dimensional problem (Bai et al., 2015).
The risk associated with expected return on asset is divided in to two categories by using CAPM
model: Systematic risk, Unsystematic risk. Systematic risk is the basic risk which exists in the
stock market while the unsystematic risk is industry specific threat in all kinds of investment.
The CAPM model states the relationship between expected returns of an investment and the risk
associated with it for determining the investment price. This model demonstrates that risks can

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be evaluated and traded in capital market. For making portfolio assets more agreeable the prices
of risky assets should be adjusted (Barberis et al., 2015).
CAPMs strengths have been assessed through several studies and the result reported in them has
shown that this model can be used by project financial managers to assess the risk of cash flow.
It also shows the exact discount rate which can be applied for evaluating the returns.
PRACTICAL USE OF CAPM MODEL
This framework is extensively used in management of investment and corporate financing and
provides expected return rates and market price of securities. This model has been quite popular
among investment practitioners; its main uses are:
1) Security comparison: Investors use this model for contrasting the rate of return on
different securities like bonds and stocks, investment funds and equities. Firms can invest
in portfolios which provides maximum rate of return and has minimum risks.
2) Pricing of asset and portfolio: The CAPM model is used for valuing investment or
portfolio. Portfolio includes any asset which has the capability of upholding its worth like
real estates, bonds, warrants, gold certificates or stocks. This is also used in Modern
Portfolio Theory for choosing appropriate investments for portfolio (Dempsey, 2013).
3) Intrinsic value: Finding intrinsic value of securities is quite a difficult task; this model is
used by analyst and investors for assessing the market value and book value of stocks. It
is regarded as better deal when the assets are traded at a rate lower than their intrinsic
value.
4) CAPM model is applied in judging investment projects having several risks as it applies
one discount rate for every project and is considered of a better quality than NPV.
ASSUMPTIONS OF CAPM MODEL
This model is used in finance for calculating an expected return rate of an asset along with the
systematic risk which is evaluated by their beta coefficient for making decisions related to
investments. The assumptions on which this model is based are that since there are no transaction
costs or taxes hence markets are considered ideal. The investors are considered averse to risks,
the investors can access information without paying for it, the entire availability and quantity of
assets remain unchanged and divisible, risk can be measured only through beta coefficient, the

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investor’s expectations regarding returns and risks remains the same, there is unlimited lending
and borrowing of asset which are free from risk at rates which do not have risk, the investors are
not price makers but price takers (Džaja & Aljinović, 2013)
For understanding this model it is important to first understand the concept of risk involved in an
investment. Individual assets have depreciation risk which is the investor’s loss; securities which
have greater risk investors expect greater returns on those investments. This risk is calculated
with the help of beta in CAPM model; beta calculates the total risk involved while investing in
specific stock. As for example: if the beta of a market is 1, security with beta 1.5 is considered
riskier while security with beta 0.5 is considered having lesser risk in the market (Fernandez,
2015).
The CAPM model can be summarized based on the following formula:
Expected return= RF rate + (Market return – RF rate)* Beta
The formula of this model can be divided in to two parts: the rate which is risk free and the risk
premium related to specific asset
1) Risk free rate involves the rate expected on investments which are assumed of having no
risks
2) Risk premium is calculated as Beta * (Market rate- RF rate) (beta times the difference
between market return and risk free return). Here beta is the risk involved in the market
related to specific security
Example:
Let’s consider a case wherein customer is planning of buying a stock; stock A has 0.75 beta,
stock B has 1.10 beta while stock C has 1.45 beta. 5.50% is risk free rate while 10.45% is
expected rate of market. Thus the expected return can be calculated with the help of this model
Stock A = 5.50 + 0.75 (10.45 – 5.50) = 9.21%
Stock B = 5.50 + 1.10 (10.45 – 5.50) = 10.96%
Stock C = 5.50 + 1.45 (10.45 – 5.50) = 12.68%

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Thus the more is the beta, the higher is the investor’s expected return and vice versa (Kisman &
Restiyanita, 2015)
ADVANTAGES OF THE CAPM
This model can be used easily and involves simple calculations which can be easily performed
for assessing different expected outcomes. This model considers only the systematic risk and
investors are assumed to be holding a diverse portfolio wherein they can eliminate unsystematic
risk. The investors can use this to provide discount rates related to investment appraisal. This
model is an efficient way of calculating equity cost as compared to the dividend growth model
(Kuo & Li, 2013).
DISADVANTAGES OF THE CAPM
This model is dependent on several assumptions thus making it unrealistic and prone to errors.
The assumption that investors can borrow or lend funds at rates which are free from risk is
impractical in the materialistic world; hence the expected return calculated in this context can be
incorrect. This model cannot be used for calculating project having particular discount rate as the
portfolio beta and the equity beta are different. Hence proxy beta is required for the project
which can be difficult and the results can also be incorrect (Mackaya & Haque, 2016). For using
this model values are needed to be assigned to rate of return which are free from risk, equity beta
and returns from stock market. The yields which are realized from short term government assets
can be used as returns which are free from risk. The stock market returns are calculated by
adding the average dividend yield and average capital gain. The returns can be negative in short
term market hence returns from long term markets are utilized but these returns tend to be
unrealistic. The stock exchanges regularly publish the beta values of all the listed companies but
as the beta value changes with time the expected return remains uncertain (Moosa, 2013). While
applying this model in investment appraisal assuming that single time period is different from the
investment appraisal’s multi period nature can be quite disadvantageous. Though CAPM
variables are expected to be same in consecutive periods but this does not hold true in the
practical world.

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LIMITATIONS OF CAPM MODEL
This model has been widely applied but some assumptions related to this model do not hold true
in the practical market scenario. There are transaction costs in real markets which can vary
according to the market participants. Thus institutional investors bear low transaction cost
compared to other investors. The real markets do not always prove efficient hence they fail to
have consistent expectations. In every asset there are risks involved like reinvestment risk,
inflation risk, liquidity risk etc. (Piamsuwannakit et al., 2015).Empirical studies have revealed
that the returns related to assets do not follow the normal distribution rules. Investors can borrow
at risk free rate under different conditions; the interest rate is lower for institutional investors as
compared to other private investors (Zaremba, 2015). Invested capital includes income tax and
capital gain tax; investors can maximize their economic utilities by taking in to consideration
taxation results. This helps in decreasing the efficiencies related to investment and also has effect
on the asset prices. Systematic risks can be limited as unsystematic risks can be diversified
(Zabarankin, Pavlikov & Uryasev, 2014). Beta coefficient cannot be considered the only risk
measurement method as it reflects only the ratio between the market return volatility and
security’s return volatility.
CONCLUSION
Previous studies have shown that CAPM was effective in calculating the asset cost although the
model was not completely perfect but its strength was correct. It provides detailed explanation
about assert prices and the expected return. Errors associated with this model can be rectified
with the help of markets having econometric methods or through advanced replacements related
to risk free rate. The principles of modern portfolio theory have been used by this model for
determining the true value of the security. This model is based on assumptions related to return

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and risk distribution, behaviors of investors and the market fundamentals which however fail to
match with the practical market conditions. The ideas on which this model is based will enable
the investors calculate the expected reward and risk.

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REFERENCES
Bai, H., Hou, K., Kung, H., & Zhang, L. (2015). The CAPM strikes back? An investment model
with disasters (No. w21016). National Bureau of Economic Research.
Barberis, N., Greenwood, R., Jin, L., & Shleifer, A. (2015). X-CAPM: An extrapolative capital
asset pricing model. Journal of financial economics, 115(1), 1-24.
Dempsey, M. (2013). The capital asset pricing model (CAPM): the history of a failed
revolutionary idea in finance?. Abacus, 49, 7-23.
Džaja, J., & Aljinović, Z. (2013). Testing CAPM model on the emerging markets of the Central
and Southeastern Europe. Croatian Operational Research Review, 4(1), 164-175.
Fernandez, P. (2015). CAPM: an absurd model. Business Valuation Review, 34(1), 4-23.
Kisman, Z., & Restiyanita, S. (2015). M. The Validity of Capital Asset Pricing Model (CAPM)
and Arbitrage Pricing Theory (APT) in Predicting the Return of Stocks in Indonesia
Stock Exchange. American Journal of Economics, Finance and Management Vol, 1, 184-
189.
Kuo, L. L., & Li, F. (2013). An Investor’s Low Volatility Strategy. The Journal of Index
Investing, 3(4), 8-22.
Mackaya, W., & Haque, T. (2016). A study of industry cost of equity in Australia using the
Fama and French 5 Factor model and the Capital Asset Pricing Model (CAPM): A
pitch. Accounting and Management Information Systems, 15(3), 618.
Moosa, I. (2013). The capital asset pricing model (CAPM): the history of a failed revolutionary
idea in finance? Comments and extensions. Abacus, 49, 62-68.

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Piamsuwannakit, S., Autchariyapanitkul, K., Sriboonchitta, S., & Ouncharoen, R. (2015,
October). Capital asset pricing model with interval data. In International Symposium on
Integrated Uncertainty in Knowledge Modelling and Decision Making (pp. 163-170).
Springer, Cham.
Zabarankin, M., Pavlikov, K., & Uryasev, S. (2014). Capital asset pricing model (CAPM) with
drawdown measure. European Journal of Operational Research, 234(2), 508-517.
Zaremba, A. (2015). Country selection strategies based on quality. Managerial Finance, 41(12),
1336-1356.