Capital Asset Pricing Model - Essay Example

CAPITAL ASSET PRICING MODEL (CAPM) Introduction The Capital Asset Pricing Model abbreviated as the CAPM has become a popular model for individual and institutional investors in the evaluation and determination of risks and returns associated with particular securities. The model was the work of William Shape who introduced it in the year 1964 to extend the work of the portfolio theory by Harry Markowitz to help investors and financial analysts to evaluate and determine the undiversifiable risk, which was associated with a given security’s return. Thus, to extend Harry Markowitz portfolio theory, William Shape introduced the element of time in the model without giving much attention to the undiversifiable risks because these factors were uncontrollable and hence beyond the management and control of individual investors. Moreover, he founded the model on several assumptions, which have over the years been a subject of criticism from the opponents and critics of the model. In this paper I am going to examine some of the pros and cons of the model; the assumptions upon which the model is founded and the criticism, which has been levelled upon the model. Pros and Cons of CAPM Model In discussing the merits of the CAPM model, it is significant to state that Shape’s model combines with Harry Markowitz’s portfolio theory to include the idea of specific and systematic risk. From this understanding, therefore, the main advantage of the CAPM model is that it reflects on the actual market portfolio thus, enabling investors to have diversified a portfolio, which enables investors to overcome the effects of unsystematic risks through portfolio diversification that eliminates and minimizes such risks. Moreover, the model has become a popular tool among firms in the calculation of the cost of capital that is attributable to the firm by combining the market rate and the risk free rate to find the required rate of return for the particular securities. Conversely, the CAPM model is capable of generating theoretically-based affiliation between the undiversifiable risk and the expected return that is imperative in the determination of the cost of equity because the model takes into consideration the immediate systematic risk facing an investor and compares it with the whole market portfolio. In addition, unlike WACC method, the CAPM model is a better too in the determination of discount rates for the overall investment appraisal projects. Notwithstanding the pros of the model, CAPM has some limitation that makes it an inefficient model for the determination of the cost of securities. Firstly, the model is based on an ineffective assumption; that of a single period time horizon, which makes it inefficient in the evaluation of multi-period appraisal investment. Secondly, the CAPM model is founded on some unrealistic assumptions such as the no taxes or transaction costs. Thirdly, the method cannot eliminate all risks to determine the true cost of securities because it is only the unsystematic risks that wash out due to diversification while the systematic risks, which are uncontrollable do not. Calculation of CAPM E (Ri) = Rf + βi[E(rm) – Rf] Where, E (Ri)=the required rate of return on asset, i Rf=the risk-free rate of return Βi=the beta of the asset’s return to the market E(rm)=the average rate of return on the capital market. Assumption of the model No transaction cost or taxes in the market No information asymmetry between different investors All undiversifiable risks are eliminated in the market Investors can lend and borrow at the risk-free rate The model assumes a single horizon transaction time period These assumptions by Shape and Lituner on the Capital Asset Pricing Model have consequential implications. The first implication is that the CAPM model is used in the assessment of “the firm’s common stocks, mergers and acquisitions, capital budgeting, and the evaluation of the exchangeable stocks and warrants” (Thomas & Francis, 1982). The assumptions made by Shape in the computation of the cost securities and capital are envisaged to create a market equilibrium. In addition, the proponents of CAPM have held that the capital market is functioning only when these assumptions are satisfied. Therefore, the CAPM model determines the amount an investor pays for an asset, and still remain satisfied and happy while holding the portfolio of assets. This simply means that CAPM model establishes the X amount of the marketplace risk, which is the predictable return. Moreover, despite shape’s model having existed for years now, the CAPM model has come under scrutiny when comparing the actual and expected returns. Many economists have questioned the model on the premise of its straightforwardness and reality when put in application with a major concern on the efficiency of the model in determining the cost of securities and equity (Banz, 1981). Moreover, they argue that the model fails to account for the small-capitalization of stocks that results from the high cost of assets and increased company risk. Nonetheless, with the several disapprovals, the model is still largely employed by firms as an efficient and appropriate model for the computation of the cost of securities (Reilly and Brown, 2011). Conversely, in agreement with Markowitz Stochastic approach of returns at a time t and second s, William Shape (1964) and Lintner (1965) came up with the above assumptions that they considered as the most efficient frontier. For instance, their assumption that investors can borrow & lend at the risk-free rate helps put all investors at an equilibrium state in terms of risk scale and premium (Heshmat, 2012, p. 504). Therefore, from this hypothesis, they presumed that every rational investor will hold a diversified portfolio, which is equivalent to the market portfolio. However, critics argue that, in reality it is difficult and irrational to assume all investors can borrow and lend at the free risk rate because each investor is faced with a different level of risk, which influences his/her lending capability. Another assumption held by the CAPM model is that it allows investors to focus on the relationship between the systematic risk & the required rate of return. This is simply inauthentic because in an idealistic world this assumption is unrealistic because most investment deliberations are made by firms and individuals. Nevertheless, the degree of these suppositions not meeting the real world realism unanimously influences the authenticity of the model, hence making these assumptions the foremost part of a typical economic doctrine. Consequently, the critics of these assumption argue that such an assumption can only exist theoretically in a perfect market for the purpose of writing literature and not in the ideal world where investors have different investment interests. However, William Sharpe sustained this assumption when he said that the counter-arguments that the assumptions are highly provisional and unrealistic are needless or uncalled for (Sharpe, 1964, p. 7). Undeniably, even though it’s factual that the actual world Capital markets are certainly not perfect and stock securities are at times mispriced, very well-built stock markets do exhibit high efficiency. The other assumption is that there are no transactional costs, a suggestion that the stock trading is valueless and cheap to arrive at and that stocks are priced to drop on the capital market procession. This is not factually true, because in realism all investments such as the acquisition of a small enterprises or businesses involve huge transactional costs. Moreover, the purchase or disposal of securities involves some costs, which are deducted before the cost of equity is derived. Furthermore, the assumption that there is no tax imposition is unrealistic because in any ideal open economy, the cost of taxes must be accounted for. Therefore, it is evident that the assumptions of no transaction costs and taxes is unrealistic and can only exist theoretically in perfect markets, which is not the case with capital markets even though very well established stock markets do exhibit high efficiency. Thus, such scenario is minimally available, for most of the dividends and capital gains returns are apparently taxed in most stock exchanges in the world are taxed, the reason why the tax puzzle is a must consideration. Besides, countless investment transactions are tied to capital gain taxes which mean different investors are taxed in a different way depending on their portfolio status. Elsewhere the model’s assumption that the investors hold diversified portfolios literally means that all the investors have a portfolio, overall depicting the stock market as a market of portfolio yet, in actuality it’s unfeasible to own the market portfolio itself (Berk, 1995). Moreover, the assumption that there is no information asymmetry in the market is unrealistic because if that was to be the case, the all investors would go for less risky securities to since they all have similar expectations about their investment returns (Kothari et al., 1995). Subsequent criticism has also been on the assumption that all investors make their investment over a single horizon transaction period. The familiarity with the stock markets indicates that it is unrealistic for the model assuming that investment occurs over a single period time horizon because in reality, investors make multiple investments within a single period time horizon depending on the viability of securities in the stock market. Moreover, despite the fact that the model suggests there exist of a positive linear relationship between the systematic risks and the return rates on securities, evidence indicates that supplementary risk variables like those suggested by the Arbitrage Pricing Theory; the macro-economic determinants, which play a significant role in influencing the interest rates and the systematic risks, hence the required rate of returns need to be taken into consideration (Reilly & Brown, 2011). Moreover, with the underlying skepticism, the proponents of CAPM have sustained their support due to the weighty advantages of the model as compared with other methods used in the computation of the required rate of return. Certainly, the model’s focus is on the systematic risk, shimmering on the realism where investors have diversified their portfolios whenever unsystematic risk has resurfaced. For instance, CAPM model takes into account the firms’ status regarding the systematic risk from a holistic stock market perspective (Watson & Head, 2007). Moreover, Fama amd French (1992: 1993: 2002) proposes that the model is a better tool for determining the cost equity because their three factor model is a similar version of the CAPM, which draws heavily from the assumptions and components of the model. Despite other models having been developed that gives contrary stances, Fama & Mcbeth (1973) holds that, risk is well measured by the asset standard deviation approach relative to the market standard deviation that is used in the computation of the investment’s volatility. However, contrary to Fama & Mcbeth’s assertion, Richard Roll in his examination of the model argued that it is not testable owing to factors such as the unfeasibility of testing the true market portfolio and the standard error of using the ineffective market proxy (Roll, 1976). In addition, Harvey and Graham (2000: 2001) argue that, despite the strong criticism levelled against the model in the computation of the cost of holding securities and equity because of its unfounded assumptions, the model remains to be a popular tool among many financial analysts and firms because of its simplicity. Conclusion In wrapping up this essay, it is justifiable saying that, despite CAPM being a popular tool among many firms, it is risk to rely on it calculating the required rate of return of an asset because it is founded on unrealistic assumptions, which can only apply to a perfect market a scenario is in unrealistic in the real world even though some capital markets exhibit high efficiency. Nonetheless, with the skepticism together with the shortcomings of the Capital Asset Pricing model, it still sustains its relevance in calculation and evaluation of the firm’s capital costs by modeling the anticipated returns and the risk. Bibliography BANZ, R., 1981. The Relation between Return and Market Values of Common Stock, Journal of Financial Economics, 9, 3-18 BERK, J.B., 1995. A Critique of Size Related Anomalies, Review of Financial Studies, 8. FAMA, E., & FRENCH, K., 1992. The Cross Section of Expected Stock Returns, Journal of Finance, 47, 427-465 FAMA, E., & FRENCH, K., 1993. 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