Subject: Commerce

Class: M. Com 1st Semester

Name of the Paper: Financial Management
Paper: Second
Titled: Capital Asset Pricing Model (CAPM)
Key Words: Capital Asset, Pricing Model, Expected Return, Risk-Free Rate.
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content is authentic and best as per my knowledge.

Dr. Manish Kumar Singh

Department of Commerce
Dr. Vibhuti Narayan Singh Campus Mahatma Gandhi
Kashi Vidyapith
Gangapur, Varanasi
Email: - singhmanishcom@gmail.com
Discussed Objective
Contents Concept of CAPM
Formula and calculation
Expected Return
Risk-Free Rate
Beta
Market Risk Premium
Assumptions of CAPM
WACC and CAPM
Significance of CAPM
Conclusion
References
Questions
Objective:
The objective of this E-content is to make the student know about the Capital Asset Pricing Model. Attempts
have been made to explain this concept with help of figure, formula and calculations

What is CAPM?
The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected
return and risk of investing in a security. It shows that the expected return on a security is equal to the risk-free
return plus a risk premium, which is based on the beta of that security. Below is an illustration of the CAPM
concept
 CAPM Formula and Calculation:

Where:
Ra = Expected return on a security
Rrf = Risk-free rate
Ba = Beta of the security
Rm = Expected return of the market
Note: “Risk Premium” = (Rm – Rrf)
The CAPM formula is used for calculating the expected returns of an asset. It is based on the idea of
systematic risk (otherwise known as non-diversifiable risk) that investors need to be compensated for in the
form of a risk premium. A risk premium is a rate of return greater than the risk-free rate. When investing,
investors desire a higher risk premium when taking on more risky investments.
 • The “Ra” notation above represents the expected return of a capital
asset over time, given all of the other variables in the
Expected Return equation. “Expected return” is a long-term assumption about how an
investment will play out over its entire life.

• The “Rrf” notation is for the risk-free rate, which is typically equal to
the yield on a 10-year US government bond. The risk-free rate should
correspond to the country where the investment is being made, and
Risk-Free Rate the maturity of the bond should match the time horizon of the
investment. Professional convention, however, is to typically use the
10-year rate no matter what, because it’s the most heavily quoted and
most liquid bond.
 • The beta (denoted as “Ba” in the CAPM formula) is a measure of
a stock’s risk (volatility of returns) reflected by measuring the
fluctuation of its price changes relative to the overall market.
In other words, it is the stock’s sensitivity to market risk. For
Beta instance, if a company’s beta is equal to 1.5 the security has
150% of the volatility of the market average. However, if the
beta is equal to 1, the expected return on a security is equal to
the average market return. A beta of -1 means security has a
perfect negative correlation with the market.
• From the above components of CAPM, we can simplify the
formula to reduce “expected return of the market minus
the risk-free rate” to be simply the “market risk
premium”. The market risk premium represents the additional
Market Risk Premium
return over and above the risk-free rate, which is required to
compensate investors for investing in a riskier asset class. Put
another way, the more volatile a market or an asset class is, the
higher the market risk premium will be.
CAPM Assumptions:
The CAPM is often criticised as unrealistic because of the assumptions on which the model is based, so it is
important to be aware of these assumptions and the reasons why they are criticised. The assumptions are as
follows (Watson, D. and Head, A. (2016) Corporate Finance: Principles and Practice, 7th edition, Pearson
Education Limited, Harlow pp.258-9).

Investors hold diversified portfolios

• This assumption means that investors will only require a return for the systematic risk
of their portfolios, since unsystematic risk has been diversified and can be ignored.
Single-period transaction horizon
• A standardised holding period is assumed by the CAPM to make the returns on
different securities comparable. A return over six months, for example, cannot be
compared to a return over 12 months. A holding period of one year is usually used.
Investors can borrow and lend at the risk-free rate of return
• This is an assumption made by portfolio theory, from which the CAPM was developed,
and provides a minimum level of return required by investors. The risk-free rate of
return corresponds to the intersection of the security market line (SML) and the y-axis
Perfect capital market
• This assumption means that all securities are valued correctly
and that their returns will plot on to the SML. A perfect capital
market requires the following: that there are no taxes or
transaction costs; that perfect information is freely available to
all investors who, as a result, have the same expectations; that
all investors are risk averse, rational and desire to maximise
their own utility; and that there are a large number of buyers
and sellers in the market.
While the assumptions made by the CAPM allow it to focus on the relationship between return and systematic risk, the
idealised world created by the assumptions is not the same as the real world in which investment decisions are made by
companies and individuals.
Real-world capital markets are clearly not perfect, for example. Even though it can be argued that well-developed stock
markets do, in practice, exhibit a high degree of efficiency, there is scope for stock market securities to be priced
incorrectly and so for their returns not to plot onto the SML.
The assumption of a single-period transaction horizon appears reasonable from a real-world perspective, because even
though many investors hold securities for much longer than one year, returns on securities are usually quoted on an annual
basis.
The assumption that investors hold diversified portfolios means that all investors want to hold a portfolio that reflects the
stock market as a whole. Although it is not possible to own the market portfolio itself, it is quite easy and inexpensive for
investors to diversify away specific or unsystematic risk and to construct portfolios that ‘track’ the stock market. Assuming
that investors are concerned only with receiving financial compensation for systematic risk seems therefore to be quite
reasonable.
A more serious problem is that investors cannot in the real world borrow at the risk-free rate (for which the yield on short-
dated government debt is taken as a proxy). The reason for this is that the risk associated with individual investors is much
higher than that associated with the government. This inability to borrow at the risk-free rate means that in practice the
slope of the SML is shallower than in theory.
Overall, it seems reasonable to conclude that while the assumptions of the CAPM represent an idealised world rather than
the real-world, there is a strong possibility, in the real world, of a linear relationship between required return and
systematic risk.
WACC and CAPM
The weighted average cost of capital (WACC) can be used as the discount rate in investment appraisal provided
that some restrictive assumptions are met. These assumptions are as follows:

The investment project is small compared to the investing organisation

The business activities of the investment project are similar to the business
activities currently undertaken by the investing organisation

The financing mix used to undertake the investment project is similar to the
current financing mix (or capital structure) of the investing company

Existing finance providers of the investing company do not change their

required rates of return as a result of the investment project being undertaken.
These assumptions are essentially saying that WACC can be used as the discount rate provided that the
investment project does not change either the business risk or the financial risk of the investing organisation.
If the business risk of the investment project is different to that of the investing organisation, the CAPM can be
used to calculate a project-specific discount rate. The procedure for this calculation was covered in the second
article in this series.
The benefit of using a CAPM-derived project-specific discount rate is illustrated in Figure 2. Using the CAPM will
lead to better investment decisions than using the WACC in the two shaded areas, which can be represented by
projects A and B.
Project A would be rejected if WACC is used as the discount rate, because the internal rate of return (IRR) of the
project is less than the WACC. This investment decision is incorrect, however, since project A would be accepted
if a CAPM-derived project-specific discount rate is used because the project IRR lies above the SML. The project
offers a return greater than that needed to compensate for its level of systematic risk, and accepting it will
increase the wealth of shareholders.
Project B would be accepted if WACC was used as the discount rate because its IRR is greater than the WACC.
This investment decision is also incorrect, however, since project B would be rejected if using a CAPM-derived
project-specific discount rate, because the project IRR offers insufficient compensation for its level of systematic
risk (Watson and Head, pp.291-2).
Signification of the CAPM:
The CAPM has several advantages over other methods of calculating required return, explaining why it has been
popular for more than 40 years:

It considers only systematic risk, reflecting a reality in which most investors have diversified
portfolios from which unsystematic risk has been essentially eliminated.

It is a theoretically-derived relationship between required return and systematic risk

which has been subject to frequent empirical research and testing.

It is generally seen as a much better method of calculating the cost of equity than the
dividend growth model (DGM) in that it explicitly considers a company’s level of
systematic risk relative to the stock market as a whole.

It is clearly superior to the WACC in providing discount rates for use in investment appraisal.
Conclusion:
The CAPM is essentially a single factor model, based on beta it may be extended to include
other variables affecting securities expected return. The major factors in this regard are
taxes, inflation, liquidity market capitalization size and price earning and market-to-book
value ratios. The risk-return trade-off is the theme of the CAPM. The non- diversifiable risk is
measured by beta coefficient.
References:
1. Khan M.Y & Jain P.K, Financial Management Mc Graw hill Education.
2. Pandey I.M, Financial Management, Vikas Publication.
3. https://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-
exams-study-resources/f9/technical-articles/CAPM-theory.html
4. https://corporatefinanceinstitute.com/resources/knowledge/finance/what-is-capm-
formula/

Questions:
1. Explain beta coefficient in CAPM.
2. What are the various assumptions of CAPM?
3. What is security market line (SML)?
4. Explain the advantages and limitation of CAPM.