Founding of Finance - Essay Example

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Foundation of Finance Based on your own research discuss whether Capital Asset Pricing Model should be used to estimate the Net Present Value of a project? Introduction In finance, Capital Asset Pricing Models (CAPM) is used to describe the relationship between risk and expected rate of return while dealing with pricing of risky securities…
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Founding of Finance Essay
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Download file to see previous pages Time value of money represents the period of time an investor placed his money in any investment. At the same time, the risk factor offers price to investors for investing their money in risky securities. The sum total of both these factors gives a clear view regarding the expected rate of return on a particular asset. It is generally calculated by using a risk measure called beta. This paper will discuss whether the capital asset pricing model should be used to estimate the Net Present Value of a project. Capital Asset Pricing Model The CAPM was originally developed by Harry Markowitz in 1952 and it was fine-tuned by others including William Sharpe. As stated above, CAPM calculates rate of return of an asset by adding the value of risk taken with duration of investment. The formula used to describe the CAPM relationship is illustrated below. Required (or expected) Return = RF Rate + (Market Return – RF Rate)*Beta. In order to clearly determine the applicability of CAPM, it is necessary to discuss the working method of the model. Assume that risk-free rate is 5%, the beta measure of the stock is 3, and the expected rate of market return for this period is 12%; then the expected rate of stock becomes; 5%+3(12% - 5%) = 26% In the opinion of Roll and Ross (1980, pp.1073-1103.), this theory had considerable significance in empirical work during 1960’s and 1970’s. However further researches on this concept have questioned its reliability and authenticity of the computation of empirical constellation of asset returns; and, many related theories have detected ranges of disenchantment with the CAPM. As a result, the most widespread CAPM underwent harsh criticisms not only by the academicians but also by financial experts. In addition, empirical researchers have gathered a range of evidences against this model during the last few decades. Those evidences questioned the model’s assumptions and argued the dead of the beta. Roll and Ross (1980, pp.1073-1103.) say that this situation led to the demand for a more potential theory and it caused the formulation of Arbitrage Pricing Theory (APT). Although, APT was developed recently, CAPM is considered as the basis of modern portfolio theory. According to Shanken (1982, pp.1129-1140), the ATP is not more susceptible to empirical verification than the CAPM. The author also challenges the testability of arbitrage pricing theory as he finds that the basic elements of testability strategy would not properly work in the case of this model. He also points out that the theory precludes the differentials of expected return that form the basic structure of the concept. Huberman and Wang (2005, pp. 1-18) claim that both the CAPM and APT show relation between expected returns of assets and their co-variance with other random variables; and an investor cannot avoid some types of risks by diversification and the concept of covariance is interpreted as a measure of such risks. There is only a single non-company factor and a single beta for CAMP and this formula only uses market’s expected return. Under CAPM, it imposes certain strict restrictions regarding individual portfolios and hence the requirements of this model also are much restrictive.However, the level of applicability of this theory is still a debatable topic in international economic conferences. In order to reacha conclusion regarding the efficacy of ...Download file to see next pagesRead More
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