CAPM Model in Evaluating Cost of Capital - Essay Example

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 effect 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 the cost of equity capital

            Rf        is a risk-free rate of return

            E(rm)  is a return from the market as a whole

            Bi        is a 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

 This figure gives a clear picture of the CAPM. Its horizontal axis shows the portfolio risk which is measured 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).