Capital Asset Pricing Model (CAPM) Assignment Help

Definition: CAPM

The Capital Asset Pricing Model (CAPM) is a mathematical model that describes the relationship between systematic risk and expected return for assets, especially equities. The CAPM model is commonly used in finance to price hazardous securities and generates predicted returns for assets based on their risk and cost of capital.

In the finance industry, the CAPM formula is commonly employed. Because CAPM calculates the cost of equity, it is critical in computing the weighted average cost of capital (WACC).

In financial modeling, WACC is widely utilized. It can be used to calculate the net present value (NPV) of an investment's future cash flows, as well as its enterprise value and equity value.

CAPM Formula and Calculation

Following is the formula and calculation of CAPM:

ERi​=Rf​+βi​(ERm​−Rf​)

Where:

ERi​=expected return of investment

Rf​=risk-free rate

βi​=beta of the investment

(ERm​−Rf​)=market risk premium​

Expected return: Given all of the other variables in the equation, the “Ra” symbol above reflects the expected return on a capital asset over time. The word "expected return" refers to a long-term prediction of how an investment will perform over the course of its whole life.

Risk free rate: The risk-free rate, which is normally equal to the yield on a 10-year US government bond, is denoted by the letter "Rrf." The risk-free rate should be appropriate for the country in which the investment is being made, and the bond's maturity should correspond to the investment's time horizon. Professional convention, on the other hand, is to always utilise the 10-year rate because it is the most regularly quoted and liquid bond.

Beta: The beta (abbreviated as "Ba" in the CAPM formula) is a measure of a stock's risk (volatility of returns) based on how its price fluctuates in comparison to the general market. To put it another way, it refers to the stock's sensitivity to market risk. If a company's beta is 1.5, for example, its security has 150 per cent the volatility of the market average. The expected return on an investment is equal to the average market return if the beta is equal to 1. A beta of -1 indicates that the security is perfectly negative in regard to the market.

Market Risk Premium: We can simplify the CAPM calculation by reducing "anticipated return of the market minus the risk-free rate" to just "market risk premium" using the above components. The market risk premium is the additional return required to pay investors for investing in a riskier asset class over and above the risk-free rate. To put it another way, the larger the market risk premium, the more volatile a market or asset class is.

The CAPM formula is used to calculate an asset's expected returns. It is based on the premise that investors should be compensated for systematic risk (also known as non-diversifiable risk) by paying a risk premium. A risk premium is an increase in the rate of return over the risk-free rate. When it comes to investing, more risky investments get a larger risk premium.

Risk and the time value of money are expected to be compensated for by investors. The time value of money is taken into consideration by the risk-free rate in the CAPM formula. The CAPM formula's other components account for the investor's willingness to take on greater risk.

A potential investment's beta is a measure of how much risk it will contribute to a portfolio that resembles the market. Beta is estimated greater than one which indicates that a stock is riskier than the market. The calculation posits that a stock with a beta of less than one will minimise a portfolio's risk.

The market risk premium, which is the projected return from the market above the risk-free rate, is then multiplied by a stock's beta. The risk-free rate is then multiplied by the stock's beta multiplied by the market risk premium. The outcome should provide an investor with the required return or discount rate to determine the asset's value.

Explore Ratio Analysis Assignment Help when risk and time value of money are compared to predicted return, the CAPM method is used to determine if a stock is properly valued.

Consider an investor who is considering a stock that is currently worth $100 per share and offers a 3% yearly dividend. When compared to the market, the stock has a beta of 1.3, indicating that it is riskier than a market portfolio. Assume that the risk-free rate is 3% and that the investor anticipates the market to grow at an annual rate of 8%.

According to the CAPM model, the stock's predicted return is 9.5 per cent:

9.5%=3%+1.3× (8%−3%)​

The CAPM formula's projected return is used to discount the stock's expected dividends and capital appreciation over the expected holding term. The CAPM method suggests that the stock is reasonably valued relative to risk if the discounted value of those future cash flows equals $100.

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CAPM: Assumptions and Limitations

Several assumptions underlying the CAPM formula have been demonstrated to be false in practise. Modern financial theory is based on two assumptions: (1) securities markets are highly competitive and efficient (i.e., relevant information about companies is widely disseminated and absorbed); and (2) these markets are dominated by rational, Trend Analysis Assignment Help and risk-averse investors seeking to maximise satisfaction from investment returns.

Despite these flaws, the CAPM formula remains popular because it is straightforward and allows for quick comparisons of investment options.

The CAPM also assumes that over the discounting period, the risk-free rate would remain constant. Assume that the interest rate on US Treasury bonds grew to 5% or 6% throughout the 10-year holding period in the previous scenario. An increase in the risk-free rate raises the cost of capital utilised in the investment, thereby overvaluing the stock.

The assumption that future cash flows can be forecast for the discounting process is the most serious criticism of the CAPM. The CAPM would be unnecessary if an investor could predict a stock's future return with a high degree of precision.

In the real world, the CAPM has major limits because most of the assumptions are impractical. Many investors do not diversify their portfolios in a systematic way. Furthermore, depending on the technique of compilation, the Beta coefficient is unstable, fluctuating from period to period. They may not accurately depict the underlying risk. Although it is based on past history, due to the unstable nature of Beta, it may not reflect future volatility of returns. The tests of Betas have shown that they are unstable and are not good predictors of future risk in the past.

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CAPM or PMP: Which is better?

When compared to PMP certification, CAPM certification is more accessible, less expensive, and requires less time and experience. However, the PMP is the most important and well-recognized project management credential in the world.

PMPs work in practically every country in a variety of industries. When hiring project managers, many employers want PMP certification since PMPs have proved the knowledge and abilities needed to lead complicated projects and manage project teams. When more than one-third of a company's project managers are PMP-certified, projects are completed on time and on budget. According to PMI's Earning Power Income Survey, project managers with a PMP certification earn a 20 percent greater salary than those without a PMP certification.

While CAPM certification isn't as well-known as PMP certification, it can indicate mastery of PMI's project management structure and processes, which might help candidates stand out when competing for jobs against others who don't have credentials.