MFIN6214 : CAPM Financial Model Discussion

Impact of CAPM Model For Expansion

The capital asset pricing model can be defined as a relationship between the systematic risk and the expected return on the investment. Systematic risk is the inherent risk, which affects the overall market. It is a very important theory for ascertaining the risk existed in the investment and also calculates the minimum amount of compensation required by the investors for taking the additional risk (Elbannan, 2014).

In the given study the owner of the U.S pharmacy wants to expand its business by establishing a new store at another location. By implementing the CAPM theory, the owner can determine the expected return from the real investment and can compare the same with actual return (Shih, Chen, Lee and Chen, 2014).

However this theory only determines the risk and return of the investors, it is not necessary that the decision of the investor is solely based on the risk and return analysis; there are various factors which can be considered by the investors.  Along with this CAPM model assumes that lending and borrowing by the investor at the risk-free rate, which is not correct in the real world (Zabarankin, Pavlikov, and Uryasev, 2014).

Although the CAPM model provides the good decision in respect of the investment, however, there are various techniques available for the investor for taking the investment decision such as NPV  method, IRR  and so on. These techniques assist the investor whether the benefits generated from the investment will be more than its initial investment.

Application of the CAPM model

The present study is related to the decision regarding the expansion of the U.S pharmacy by opening the new store at the same location. Owner of the business should apply the capital asset pricing model, for determining to take a decision regarding opening a new store as it may be risky for the investor to open the new store if the investor cannot achieve the profit from the business (Elbannan, 2014). Since by applying this theory investor can get to know about whether the expected return generated from the new store would be equal to the risk-free rate of return and the market risk premium if the not then it is not beneficial for the investor to open the new store of the company at another place. Further CAPM considers the systematic risk for measuring the required rate of return of the company. If the investor not applies the CAPM model then, the investor will not consider this risk at the time of investment, which is generally unavoidable by the investor. Thus, by applying this model, expected return from the investment calculated after considering the market risk of the industry (Kogan, and Papanikolaou, 2014).

Therefore investor by applying the capital asset pricing model can identify the expected required return on the investment, and by comparing it from the return of the investment can take the better decision.

References:

Elbannan, M.A., 2014. The capital asset pricing model: an overview of the theory. International Journal of Economics and Finance, 7(1), p.216.

Kogan, L. and Papanikolaou, D., 2014. Growth opportunities, technology shocks, and asset prices. The journal of finance, 69(2), pp.675-718.

Shih, Y.C., Chen, S.S., Lee, C.F. and Chen, P.J., 2014. The evolution of capital asset pricing models. Review of Quantitative Finance and Accounting, 42(3), pp.415-448.

Zabarankin, M., Pavlikov, K. and Uryasev, S., 2014. Capital asset pricing model (CAPM) with drawdown measure. European Journal of Operational Research, 234(2), pp.508-517.