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Disscuss the relevance of the capital asset pricing model (CAPM) to a company seeking to evaluate its cost of capital - Essay Example

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Whenever a company invests in a new project or when an investor invests in some shares, there is always some risk involved (unless the investment is made in risk-free securities such as “gilts”). However, a company can also reduce its overall exposure to such…
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Disscuss the relevance of the capital asset pricing model (CAPM) to a company seeking to evaluate its cost of capital
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CAPM Model in Evaluating Cost of Capital Whenever a company invests in a new project or when an investor invests in some shares, there is always some risk involved (unless the investment is made in risk-free securities such as “gilts”). However, a company can also reduce its overall exposure to such investment-related risk if it invests in a number of projects with the view that even if the more risky projects perform badly, the less risky projects will cover up for the loss, resulting in an average return from the portfolio that is pretty much closer to what company expects i.e. cost of capital. (Burton, 1998)
The CAPM had its origin from the model of portfolio choice developed by Harry Markowitz. In the model, an investor is assumed to decide on the investment portfolio at time t-1 with an expected return at time t. Since the investors are assumed to be risk averse, the data that they care about are the mean and the variance of their one period investment return. “As a result, investors choose “mean-variance-efficient” portfolios, in the sense that the portfolios: 1) minimize the variance of portfolio return, given expected return, and 2) maximize expected return, given variance. Thus, the Markowitz approach is often called a “mean-variance model” (Eugene F. Fama).
The CAPM is principally based on the measurement of systematic risk and its affect on required returns and share prices. (Investopedia, 2009)
The CAPM model can be translated into the following formula:
[E(ri) = Rf + Bi ( E (rm) – Rf )]
Where E(ri) is cost of equity capital
Rf is risk-free rate of return
E(rm) is return from market as a whole
Bi is beta factor of the individual security
Source: EM applications, 2009
Graphically, CAPM can be drawn as follows:

Mean-Variance-
Efficient Frontier
with a Riskless Asset
Minimum Variance
Frontier for Risky Assets
σ(R)

This figure gives a clear picture of the CAPM. Its horizontal axis shows the portfolio risk which is measure by the standard deviation of portfolio return. Its vertical axis is the expected return. The curve is the minimum variance frontier which “traces the combination of expected return and variance at different levels of expected return” (Eugene F. Fama). This shows the obvious trade-off between risk and expected return.
“At point T, the investor can have an intermediate expected return with lower volatility. If there is no risk free borrowing or lending, only portfolios above b along abc are mean-variance-efficient, since these portfolios also maximize expected return, given their return variances” (Eugene F. Fama).
Works Cited
Burton, Jonathan (1998). Revisiting The Capital Asset Pricing Model. Available from:
[November 16, 2009]
EM applications. (2009). Capital Asset Pricing Model (CAPM). Emapplications.com. Available from; [November 16, 2009]
Eugene F. Fama, Kenneth R. French. "The Capital Asset Pricing Model: Theory and Evidence∗." 2004.
Investopedia (2009). Capital Asset Pricing Model – CAPM. Available from: [November 16, 2009] Read More
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