Capital asset pricing model

Definition

The capital asset pricing model (CAPM) is a financial formula used to determine the expected return on an investment based on its risk compared to that of the market. It establishes a linear relationship between the expected return of an asset and its systematic risk, measured by beta. CAPM is crucial for evaluating the cost of equity capital, pricing risky securities, and making investment decisions that align with risk tolerance and expected return objectives.

5 Must Know Facts For Your Next Test

1. CAPM is expressed using the formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate), where 'Market Return' is the average return of the market portfolio.
2. The model assumes that investors are rational and will seek to maximize their returns for a given level of risk, relying on diversification to eliminate unsystematic risk.
3. CAPM helps companies determine their cost of equity capital, which is essential for capital budgeting decisions and assessing investment projects.
4. The model has been widely criticized for its assumptions, such as the existence of a risk-free rate and the idea that markets are efficient; however, it remains a foundational concept in finance.
5. CAPM can be applied not only to stocks but also to any asset where risk can be quantified relative to the overall market, making it versatile in financial analysis.

Review Questions

• How does CAPM relate to stock valuation and what role does beta play in this relationship?
  • CAPM plays a critical role in stock valuation by providing a method for estimating the expected return based on risk. Beta serves as a key component of this relationship by measuring how much a stock's price moves relative to market movements. A higher beta indicates greater volatility and risk compared to the market, leading investors to require a higher expected return for holding that stock.
• Discuss how CAPM influences a company's decision-making process regarding new investments and capital structure.
  • CAPM influences a company's decision-making by providing a clear framework for assessing the expected return required from new investments based on their associated risks. By calculating the cost of equity using CAPM, companies can make informed choices about which projects align with their return expectations and overall capital structure. This helps ensure that investment decisions contribute positively to shareholder value while managing financial risks effectively.
• Evaluate the effectiveness of CAPM as a tool for determining expected returns compared to alternative models, considering its limitations and practical applications.
  • While CAPM remains popular for estimating expected returns due to its simplicity and foundational concepts in finance, its effectiveness can be questioned when compared to alternative models like the Fama-French three-factor model. Critics point out CAPM's reliance on unrealistic assumptions like market efficiency and constant betas. Despite these limitations, CAPM's practical applications in corporate finance and investment analysis make it valuable, especially when used alongside other models for a more comprehensive evaluation of risks and returns.

Related terms

Beta: A measure of an asset's volatility or risk in relation to the overall market, indicating how much the asset's price is expected to move in response to market changes.

Risk-Free Rate: The return on an investment with no risk of financial loss, typically represented by government bonds, used as a baseline for assessing the expected returns on riskier assets.

Market Portfolio: A theoretical portfolio that includes all available assets in the market, weighted according to their market values, representing the highest level of diversification.