Capital asset pricing model
According to Ross, Westerfield and Jordan (2008) capital asset pricing model is the equation of the security market line showing the relationship between expected return and beta. It is use to calculate the rate of return for risky asset. CAPM state that expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium.
Formula for CAPM
E(Ri)=Rf + [{E(Rm) - Rf}] βi
Where, E(Ri)= return required on financial asset I, Rf= risk free rate of return, E(Rm)= average return on the capital market, βi= beta value for financial asset i (Mike 2013)
There are some assumptions in which CAPM depends. They are as follows.
Investors choose investment based on expected return and standard deviation
Investor can barrow or lend …show more content…
This method is also better than dividend growth method to calculate cost of equity
This method clearly create theoretically derived relationship between systematic risk and required return
Disadvantages of CAPM
To find CAPM, there are some values such as the return on the market, EPR, risk free rate of return and equity beta should be assigned. In some cases, assigning these values is difficult. For examples, government debt, yield on short term that is use as risk free rate of return is not fixed.
To find the value of EPR is also difficult. Sometime stock market can provide negative return if the share price fall. Sometime it is hard to calculate a project specific discount using this method. For example, proxy companies seldom undertake only one business which make hard to find out proxy beta.
CAPM variable can assumed constant in successive future periods but experience indicates that is not true in reality.
Critique of CAPM
Berkman (2013) suggest that this model is competently trustworthy. He future point some of its weakness which are as
According to Ross, Westerfield and Jordan (2008) capital asset pricing model is the equation of the security market line showing the relationship between expected return and beta. It is use to calculate the rate of return for risky asset. CAPM state that expected return of a security or a portfolio equals the rate on a risk free security plus a risk premium.
Formula for CAPM
E(Ri)=Rf + [{E(Rm) - Rf}] βi
Where, E(Ri)= return required on financial asset I, Rf= risk free rate of return, E(Rm)= average return on the capital market, βi= beta value for financial asset i (Mike 2013)
There are some assumptions in which CAPM depends. They are as follows.
Investors choose investment based on expected return and standard deviation
Investor can barrow or lend …show more content…
This method is also better than dividend growth method to calculate cost of equity
This method clearly create theoretically derived relationship between systematic risk and required return
Disadvantages of CAPM
To find CAPM, there are some values such as the return on the market, EPR, risk free rate of return and equity beta should be assigned. In some cases, assigning these values is difficult. For examples, government debt, yield on short term that is use as risk free rate of return is not fixed.
To find the value of EPR is also difficult. Sometime stock market can provide negative return if the share price fall. Sometime it is hard to calculate a project specific discount using this method. For example, proxy companies seldom undertake only one business which make hard to find out proxy beta.
CAPM variable can assumed constant in successive future periods but experience indicates that is not true in reality.
Critique of CAPM
Berkman (2013) suggest that this model is competently trustworthy. He future point some of its weakness which are as