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Real Cost of Capital - Assignment Example

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This paper “Real Cost of Capital” explores the concept of capital asset pricing model as a major finance tool that is used in capital budgeting. This is the first model to quantify risk and explain asset prices by linking the individual asset's risk to the market risk…
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Real Cost of Capital
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Download file to see previous pages Also, other academics criticize the models' failure to incorporate other determinants of risks such as firm size, book-to-market ratio, etc. then the plain correlation of the risk of the assets to the market. Despite these criticisms, many practitioners in the corporate world still use CAPM for capital budgeting. These issues are probed in this paper.
CAPM or the capital asset pricing model has been a tool in modern finance that has been extensively used for capital budgeting. The capital asset pricing model is useful in estimating the required return on an equity stock of a company (Perold 2004). Under the principle of finance that rational investors will require higher returns to compensate them when they undertake projects with higher risks, CAPM captures this concept which has made it popular in corporate finance works of literature as well as widely accepted in practice (Mullins 1982). What is unique in this model is the concept of beta in its equation, which aims to measure and predict the risk premium of a certain stock (Chatterjee, Lubatkin, Schulze 1999). Beta in CAPM is the measure of the systematic risk or the risk that cannot be diversified because it is not inherent to the company (Perold 2004).
CAPM has been empirically tested and its prediction has been consistent with the average market returns, at least with the 1926-1963 data set (Fama & French 2006). However, the CAPM has also been challenged by many academicians, most notably by Banz in 1981 who finds that firm size and level of capitalization is significant on the stock returns (Jagnnathan & Mcgrattan 1995), and Fama and French who question the role and significance of beta in predicting the risk premium of an asset (Jagnnathan & Mcgrattan 1995; Fama & French 2006).
In order for CAPM to hold, there are at least four assumptions that lie beneath the theory.  ...Download file to see next pagesRead More
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