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the time value of the money. The more the investment is held, the higher would be the return required by an investor as money loses its value over time (Fama, 2004).
The Discounted Cash Flow (DCF) method on the other hand is a method that is used in order to ascertain the charm of any particular investment. The DCF technique uses cash basis rather than accounting valuation techniques in order to analyze the attractiveness of any particular investment. Hence it considered less subjective because of its cash flow techniques. The cash flows that would be gained from any particular project are discounted using an appropriate discount rate based upon the market rate and the investor’s expectations in order to reflect the time value of money. If the value deduced after discounting i.e. the present value is greater than the outflows (usually required at the current time horizon), the project is accepted (Kaplan, 1994).
The CAPM is used to calculate the required return of an investor. This required return is then used as a basis for the DCF method in order to ascertain the Present Value of any given project/investment. The CAPM is used in order to calculate the discount rate and this discount rate is further used within the DCF technique in order to value an investment or an asset. The CAPM uses the risk free rate in order to reflect the time value of the money. The market risk premium (i.e. the expected return rate within the market less the risk free rate) is multiplied with the relevant project beta; this project beta denotes the investor’s risk (Eugene et al, 2011; Kaplan, 1994).
Usually, companies use the CAPM to ascertain the cost of equity. This cost of equity is further used to calculate the Weighted Average Cost of Capital (WACC) of a firm and finally this WACC is used within the DCF technique in order to calculate the Net Present Value (NPV) of a project/investment. The WACC within the NPV technique denotes the required
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Naturally, the discussion begins with an overview of the ideas put forward in the aforementioned paper. The typical textbook solution to capital budgeting is through computing the Net Present Value (NPV) of a project by using the cost of capital as the discount rate to identify the projects that lead to maximization of the value of the firm.
Investing in portfolios has two advantages. First of all, it reduces the investor’s risk and secondly it improves the returns that the investor can earn. Therefore, many large investors and investment banks invest in portfolios or in a basket of investment rather than investing in one type of security or company.
Capital Asset Pricing Model.
CAPM (Capital Asset Pricing Model) The CAPM model has emerged to be one of the most important tools in making a fundamental decision related to the investment management. It measures the relationship between the expected rate of return and the risk involved in a particular investment The CAPM tool signifies the linear relationship between the non diversified systematic risks which is measured by beta ?
Accordingly the equation used for CAPM is: E(Ri) =RF +?i [E(RM) - RF ] (CAPM: Theory, Advantages and Disadvantages, 2008) However, there are many limitations as the assumptions can cause certain deviation in the application of this process, between the reality and the model.
The beta coefficient is like a share's market sensitivity pointer. For instance, if the average rate of return on the stock market rises or falls by 10 per cent, how does the rate of return on an individual share react If the share's rate of return similarly rises or falls by 10 per cent in exact harmony with the market, then one says that the share has a beta coefficient of 1.0; it is just as risky as the 'average' shares in the market.
The formula is given as: risk free rate added to beta multiplied by the difference of market return and risk free rate.
Beta in this case represents a stock’s rate of rise and fall in comparison to the market in general. It is a measure of the sensitivity of an assets
because of this assumption, it is assumed that there is no information asymmetry in the market, implying that all investors have the same publicly available information concerning securities in the market. Thus, since investors have similar information, the models assume that
The paper "Capital asset pricing model (CAPM)" gives the detailed information about Developments in the Capital Asset Pricing Model. The foundation of Capital asset pricing model was established in an article of a finance journal in the year 1963 named, Capital Asset Prices: A theory of market equilibrium under conditions of risk.
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