Capital Asset Pricing Model - Assignment Example

CAPM Introduction The CAPM (Capital Asset Pricing Model) was established by Harry Markowitz in the year 1952. A major feature of this model is that it accepts stakeholders are risk hostile. The assumption granted as per this model also asserts that at the time of selecting among portfolios, stakeholders are only are concerned about mean and variance of their one dated investment return. Guided through these assumptions, this model provides a precise prediction about the relationship between risk and return. This paper herewith intends to explain the answer of risk-return relationship obtainable through CAPM further moving towards justifying if CAPM provides the good account for pricing or not. Based on the rationale obtained in relation to these mentioned fields, the paper aims at concluding with regard to the relevance of CAPM for corporate managers (Fama & French, 2003). Assessment of CAPM’s Answer to the Risk-Return Relationship CAPM is valued high owing to its ability to guide investment projects through accurate calculation about the relationship between the risk and return. This relationship provides two major functions. First, it serves as a standard regarding the rate of return for assessing the potential investments and second, it helps generating a cultured guess, rather than a biased one, with regard to return on assets, which have not been traded in the market place. The common concept behind CAPM is that investors must be remunerated in two ways, i.e. time assessment of money as well as risk (Leonard, Loli, Kralj & Vlachos, 2012). The relationship of risk and return can be described with regard to the fact that low level of risk is connected with low potential returns and high risks are connected with high potential returns. In general terms, ‘risk’ is considered as negative concerning the fact that risks imply investments and their returns as conditional, wherein investors may or may not be able to generate their desired level of profit. It is thus that CAPM suggests, considering high risk of return, investors must be conscious about their possible risk tolerance at the time of selecting investment projects for their portfolio. Notably, according to the model, there are two types of risks those can be possible when selecting investment, such as systematic risks and unsystematic risks (Leonard, Loli, Kralj & Vlachos, 2012). Do CAPM Provide a Good Account for Pricing a Firm’s Debt or Equity? CAPM helps to calculate the cost of equity of a private company by assessing the betas and thereafter, calculate the cost of debt by estimating risk of default as well as cost of debt after tax. In a private company, the originations of risks and returns are calculated using the past prices of an asset that act as risk parameters to estimate the cost of equity. However, as this particular measure is often criticized to be highly affected due to biases and errors in past evaluations, corporate managers need to practice risk measurement based on an approach, which does not require the past prices but logically draws upon present indicators to forecast future return possibilities (Damodaran, n.d.). It is in this context that CAPM helps in calculating the cost of debt by estimating a suitable bond rating of the company depending on its present performance. For instance, if the debt of a firm is that of a long term, the cost of debt can be calculated by utilizing the expense of interests and the outstanding of the debts. Therefore, from the above discussion it can be stated that CAPM provides a good account for pricing a firm’s debt or equity (Damodaran, n.d.). Is CAPM Relevant to the Corporate Managers? CAPM is relevant to corporate managers owing to its various strengths and capabilities to critically evaluate the basics of the financial market. To be noted in this context, as can be observed through the evaluation of its various features, CAPM helps calculating the possible risk premium for assets, which is important for the corporate managers of the modern era. As it also describes the changes in risk premium through assets, it is of considerable significance to the corporate managers, allowing the required amount of relevant information regarding tradeoff risks and returns, which is quintessential for the corporate managers (Naylor & Tapon, 1982). Analysts have also given much credit to this model as it helps the corporate managers in selecting portfolio for profitable investments through controlled risks (Naylor & Tapon, 1982). Based on its various advantages, this model can be considered as fair, in terms of its effectiveness in accounting for pricing related to the firm’s cost of equity as well as cost of debt. This particular feature also makes it relevant to the corporate managers. Emphasizing the behavior of demand and equilibrium in the assets market, it acts as a dynamic model covering group of agents. It is also used to describe the temporary condition of the economy, expanding the scope of evaluation for the investors in the industrial contexts. It also provides information related to uncertainty aspects, which is involved in high risk and in calculation of risk premiums for the assets. In recent years, the model has also been used by corporate managers to develop advanced models to solve the accounting problems, as per the requirement of the company, which also increases its relevance (Bohm, 2002). Nevertheless, CAPM also has some limitations. One of these limitations of the model is at the time of calculation of discount rate, finding appropriate proxy betas become obscure. In the similar context, the assumption of CAPM is often argued to be unrealistic and highly prone to biases. It is in this context that when testing CAPM, the data is obtained on the basis of expected as well as forward looking data, which again may get bias if faced with a limitation of erroneous forecasted data (ACCA, 2015). However, when evaluated on these limitations against its strengths, the model can still be assumed as relevant for corporate managers, as its gaps are deemed controllable with the help of predefined measures. Conclusion From the above discussion, it can be stated that CAPM is effective providing answers concerning the relationship between risk and return besides being a good account for pricing. From the above discussion, it can be concluded that this model is also regarded as dynamic model, which indicates its wide applicability in risk measurement and decision-making to corporate managers, when deciding on profitable investment plans. Although certain limitations have also been identified as affecting the efficiency of this model, owing to the fact that those limitations can be controlled with greater knowledge of corporate managers, its relevance in today’s business decision-making context does not gets hindered. References ACCA. (2015). CAPM: Theory, Advantages and Disadvantages. Retrieved from http://www.accaglobal.com/in/en/student/acca-qual-student-journey/qual-resource/acca-qualification/f9/technical-articles/CAPM-theory.html. Bohm, V. (2002). CAPM Basics. Department of Economics, 1-33. Damodaran, A. (n.d.). Private Company Valuation. Profiles, 179-233. Fama, F. E. & French, R. K. (2003). The CAPM: Theory and Evidence. University of Chicago, 1-26. Leonard, F., Loli, B., Kralj, B. & Vlachos, V. (2012). The Capital Asset Pricing Model (CAPM). Investment and Valuation of Firms, 3-21. Naylor, H.T. & Tapon, F. (1982). The Capital Asset Pricing Model: An Evaluation of Its Potential as A Strategic Planning Tool. Management Science, 28(10), 1166-1173. Read More