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CAPM - Term Paper Example

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The paper will start with the definition and presentation of capital asset pricing model and show why it is not a valid method of estimation in the capital asset market. Assumptions…
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Download file to see previous pages Since capital asset pricing model is not a valid method, there are alternative methods used instead of CAPM. Alternative method includes weighted average cost of capital plus the tailor made marker risk assessment method. The paper ill illustrate the reason as to why the weighted average cost of capital is a better method/approach than the capital asset pricing model method. A brief conclusion will summarize why capital asset is a biased methodology and present why WACC is a better method in assessing cost of capital.
Beta measures investment risk of non-diversified venture. Beta measures risk of an already diversified investment portfolio. Beta risk is the only risk which investors do receive a relatively high return than the risk free interest rate. The beta part of asset serves to measure riskiness in an asset. Beta measures individual asset risks and represents non diversifiable risk part of an asset. Beta of a portfolio is an average measure of all individual betas of an asset. Individual asset standard deviation squared measures risks associated with deviations/fluctuation of asset rate of return over time.
According to the CAPM, investors are compensated for taking risk and so as to capture the element of time value of money in valuation of risky assets. The risk free rate captures the time value of money in the above shows how an investor ought to be invested for putting resources in a certain investment over time. Beta is a measure of risk in the model2.
The decision rule in the model is that an investment is only undertaken when the expected return meets required return in an investment3. A security market line shows the relationship between CAPM results and various risks in the capital market. Risky assets are the assets which are traded in the asset market. Risk free assets refer to the process of lending and borrowing of assets with a certain interest rate.
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