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Capital Asset Pricing Model - Essay Example

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Capital Asset Pricing Model Introduction The Capital Asset Pricing Model (CAPM) was initially developed by Harry Markowitz in 1952. The model was later on modified by other practitioners including William Sharpe. This theoretical framework is widely used to describe the relationship between expected rate of return and possible risk elements while addressing the pricing of risky securities…
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Download file to see previous pages This model has been heavily criticised and debated over the past decades, and many of the economists are of the opinion that this framework is not adequate enough to assess various risk factors comprehensively. However, none of the opponents could introduce a potential alternative to this concept till date. This paper will critically analyse the applicability of the CAPM in corporate finance applications in the context of modern business environment. Corporate applications of CAPM Hillier et al (2008, section 5.1) provide a detailed view of the corporate applications of the capital asset pricing model. Through a well integrated theoretical concept and empirical evidences the authors give readers an easy understanding of the applicability of CAPM in corporate finance. Through this section, the authors address the misconception that the CAPM theory is applicable only to investment purposes. The application of capital asset pricing model together with mean variance analysis is greatly supporting corporate managers in decision making process today (Grinblatt & Titman 2003, p. 132). The author argues that a manger is most likely to lose his job if his organisation is continuously struggling with declining stock prices (ibid). Hence every corporate manger is forced to improve the firm’s stock prices at any cost. For this, the manager needs clear understanding of the different elements that determine share value. Such knowledge would greatly assist corporate managers to determine what actions would improve the stock value and thereby serve the interest of stockholders and directors. For instance, the combined application of CAPM and mean variance analysis may help firms to hedge their risk elements to a great extent and “diversify their portfolios of real investment projects” (Grinblatt & Titman 2003). The CAPM model also benefits multinational corporations to scrutinise their capital expenditure decisions. Management theories and historical evidences clearly indicate that thoughtless capital expenditures would lead to corporate failures. Top executives are extremely concerned with the firm’s capital expenditure strategies as they determine the organisation’s levels of sustainability. At this juncture, CAPM assists regulators to frame their capital expenditure strategies by focusing on various factors affecting capital expenditure. This concept is also useful for financial managers to arrive at reasonable conclusions on how to value real assets. Although many of the critics claim that CAPM model cannot be used for valuing real assets, majority of corporations are still cantered on this model. However, scholars like Lee et al (2009) strongly believe that CAPM can be very useful in real asset valuation. While analysing the historical growth phases of CAPM, it seems that corporate managements have been using this model in their all areas of financial analysis and planning since the development of this concept. Scholars opine that capital budgeting is one of the major corporate applications of the CAPM. If it is possible to predict the systematic risk associated with a project accurately, then the CAPM can be applied to compute the risk adjusted discount rate which is essential to compensate the organisation for the risk elements of the project. “ ...Download file to see next pagesRead More
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