The Uses and Limitations of CAPM in Evaluating Potential Investments in the Firms Shares - Essay Example

The Capital Asset Pricing Model (CAPM)

The CAPM (capital asset pricing model) refers to a model describing the relationship occurring between the expected returns and the risk; and is used in the perspective of pricing the risky securities. The general ideology behind the CAPM is the fact that the investors necessitate for compensation in two major ways, that is; the risk, and the time value of money. The risk-free (rf) rate represents the money’s time value in the subsequent formula and tends to compensate the investors due to the placement of money into any investment framework over a given time period. The other part of the formula is representing the risk and computing the total amount of compensation that the investor is in need of for assumption of additional risks. This is computed by taking the risk measure comparing the assets’ returns to the entire market over a given time period, and towards the market premium (Rm-rf) (Bollen, 2015). Here, the Capital Assets Pricing Model asserts that the anticipated security returns or the portfolio equals to the rates thriving on the risk-free security in addition to the risk premium.

The Uses and Limitations of CAPM in Evaluating Potential Investments in the firm’s Shares

A principal CAPM advantage is with regards to the objective nature based on the estimated equity costs’ that can be yield by the model. The CAPM cannot actually be used in segregation due to the fact that it necessarily makes dire simplifications on the financial markets’ world. The financial managers can hence use it in supplementation of other methodologies as well as their own judgments on the basis of their attempts of trying to develop useful and realistic equity calculations’ costs.

Beta is often used as a standard CAPM systematic risk measure. It tends to gauge the security return tendency of moving in parallel with the entire stock market return. The main way of putting beta into consideration is the perspective of gauging the security’s volatility levels relative towards the market’s volatility. For instance, a stock with a subsequent beta of 1.00, which is considered as the average systematic risk level, tends to rise and fall at similar percentage level as that of a broad market index. The stocks with the beta value of more than 1.00 often fall and rise by a greater percentage as compared to the entire market situation (FAMA & FRENCH, 2004). This hence means that they are mutually endowed with high systematic risk’s levels and are thus very sensitive towards the market changes. On the other hand, a given stock endowed with a beta of less than 1.00 has lower systematic risk level and is overly less sensitive to the market swings.

In a freely competitive fiscal market, as described by the CAPM, no single security can entirely sell for longer periods at prices lower enough to capitulate more than the appropriate SML returns. The security can then be attractive as compared to many other securities with similar risks, and investors can entirely bid on the subsequent price until the expected returns falls to appropriate SML positions. If the expected return fails to beat or meet the targeted returns value, then such an investment should be dismissed. The perceived security market line tends to plot the CAPM’s outcome for all varying risks (betas) (PEROLD, 2004).

The uses and limitation of CAPM as a source of discount rates to be used in capital budgeting for the firm’s direct investments

The principal benefit of the Capital Assets Pricing Model is an objective estimated costs’ nature with regards to the equity that can be yield by the model. The CAPM cannot be utilized in isolation due to the fact that it essentially simplifies the financial market’s segment. Financial managers can hence use it in supplementing other various techniques as well as their own judgment with regards to the attempts of developing useful and realistic equity cost calculations.

The contemporary financial theory sets basis on two main assumptions. The first assumption is that; the securities markets have very efficient and competitive trends including the relevant data and information regarding various companies that are universally and quickly absorbed and distributed. Such markets are essentially dominated by the rational and risk-averse investors that seek the maximization of satisfactory investments’ returns WESTON, 1973).

The initial assumption presumes that a fiscal market is populated by the highly sophisticated and well-informed sellers and buyers. The other assumption gives an explanation on some of the investors caring about wealth while preferring more to less. Additionally, the hypothetical modern financial investors’ demands a form of premium in form of the higher anticipated returns for the assumed risks.

Although the two assumptions tend to constitute the foundation of the contemporary financial theory, CAPM’s formal development involves many other specialized limiting assumptions. They include the frictionless markets with no imperfections such as the taxes, transaction costs, and various restrictions that are subjected on short selling and borrowing (Bollen, 2015). On the other hand, the model requires various limiting assumptions with greater concern on the security’s statistical nature as regards to the returns and the investors’ preferences. The investors are finally assumed to be on agreement on the most probable performance securities on the basis of a universal time horizon.

Even though the CAPM’s assumptions seem to be unrealistic in nature, such reality-based simplification is usually necessary in development of significant models. The true model test not only lies on the extent of reasonableness of the underlying assumptions but as well in the usefulness and validity of the entire model’s prescription. The CAPM’s assumptions tolerance that is however fanciful, often allows for the derivation of concrete, idealized, model with respect to the manner whereby the financial markets tend to measure the subsequent risks before transforming it into the anticipated returns (Dempsey, 2012).

The aspect of portfolio diversification is also one of the most essential elements posed by CAPM with regards to perspectives behind direct investments. CAPM deals with the returns and risks on the financial securities while precisely defining them. The investor’s return rates are received from buying the common stock while holding it for a certain time period that is equivalent to received cash dividends plus the capital gain in the course the holding period before being divided by the securities’ purchase price.

As much as the investors might expect some specific returns when they purchase some specific stocks, they might be pleasantly surprised or disappointed, since the stock prices’ fluctuations end up into the fluctuating returns. The common stocks are therefore considered as being the risky securities. Contrary, due to the returns on part of the securities, for instance, the Treasury bills, they will not actually deviate more from the expected returns, and are hence considered as being riskless securities (Dempsey, 2012). The financial theory tends to define risk as a possibility of actual returns deviating from the expected returns, as well as the degree of the potential fluctuation towards determination of the risk degree.

The most ardent CAPM’s underpinning is the ultimate observation that the risky stocks may be combined such that the portfolio becomes less risky as compared to any of its esteemed components. Even though such diversification seems to portray familiar notions, it might be valuable to review the way in which the aspect of diversification decreases risk.

For example, assumptions can be made on the supposed two Firms located within an isolated island with the chief industry being tourism. One firm manufactures the suntan lotion, and its stock predictably tends to perform well during the sunny seasons and poorly during the rainy seasons. The other firm produces the disposable umbrellas, and its stock equally performs poorly during sunny years and highly during rainy ones. The other detail is that; each company earns an average return of around 12%. Therefore; in purchasing either of these stocks, investors tend to incur great amount as regards to risks due to the stock price’s variability driven by the fluctuations in the weather conditions. However, investing a half of the funds in suntan lotion firm and the other half in the umbrella manufacturing firm will result in a 12% return regardless of the prevailing weather condition. The portfolio diversification hence works towards transforming the two uncertain stocks, with each having an average of 12% return rate, into the riskless portfolio with a certainty of receiving the expected 12%. However, providing there is lack of parallelism with regards to the securities returns, diversification always tends to reduce the underlying risk.

Conclusion

From all these discussions, it can thus be ascertained that there exists no perfect model in nature, but each model should bear some few features that tends to make it applicable and useful. As much as it often receives various criticisms for the unrealistic assumptions, CAPM offers a more useful result as compared to other models such as WACC and DDM in most situations. It is can easily be computed and stress-tested. When used in combination with the other investment mosaic’s perspectives, it can offer the unparalleled yield data supporting or eliminating the potential investment.

Reference List

Bollen, J. (2015). Practical Applications of Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions David Blitz, Eric Falkenstein and Pim van Vliet. Practical Applications, 2(3), pp.1-4.

Dempsey, M. (2012). The CAPM: A Case of Elegance is for Tailors?. Abacus, 49, pp.82-87.

FAMA, E. F., & FRENCH, K. R. (2004). The capital asset pricing model: Theory and evidence. Journal of Economic Perspectives, 18, 25-46.

PEROLD, A. F. (2004). The capital asset pricing model. The Journal of Economic Perspectives, 18(3), 3-24.

WESTON, J. (1973). Investment decisions using the capital asset pricing model. Financial Management, 25-33.