Capital Asset Pricing Model, Efficient Market
Table of Contents
Question # 1a
The finance profession has had difficulty in developing a practical approach to measuring risk premiums and thus investor’s required rate of return , but financial managers most often use a method called the capital asset pricing model (CAPM) .The capital asset pricing model (CAPM) is the standard risk-return model used by most academicians and practitioners. The important concept of CAPM is that investors are rewarded for only that portion of risk which is not diversifiable. This non-diversifiable risk is termed as beta, to which expected returns are linked. Problems can arise when using the CAPM to calculate a project-specific discount rate. For example, one common difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The proxy beta for a proposed investment project must be disentangled from the company’s equity beta. One way to do this is to treat the equity beta as an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, information about relative shares of proxy company market value may be quite difficult to obtain. A similar difficulty is that the ungearing of proxy company betas uses capital structure information that may not be readily available. Some companies have complex capital structures with many different sources of finance. Other companies may have debt that is not traded, or use complex sources of finance such as convertible bonds. The simplifying assumption that the beta of debt is zero will also lead to inaccuracy in the calculated value of the project-specific discount rate.
One disadvantage in using the CAPM in investment appraisal is that the assumption of a single period time horizon is at odds with the multi-period nature of investment appraisal.
While CAPM variables can be assumed constant in successive future
Question # 1a
The finance profession has had difficulty in developing a practical approach to measuring risk premiums and thus investor’s required rate of return , but financial managers most often use a method called the capital asset pricing model (CAPM) .The capital asset pricing model (CAPM) is the standard risk-return model used by most academicians and practitioners. The important concept of CAPM is that investors are rewarded for only that portion of risk which is not diversifiable. This non-diversifiable risk is termed as beta, to which expected returns are linked. Problems can arise when using the CAPM to calculate a project-specific discount rate. For example, one common difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The proxy beta for a proposed investment project must be disentangled from the company’s equity beta. One way to do this is to treat the equity beta as an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, information about relative shares of proxy company market value may be quite difficult to obtain. A similar difficulty is that the ungearing of proxy company betas uses capital structure information that may not be readily available. Some companies have complex capital structures with many different sources of finance. Other companies may have debt that is not traded, or use complex sources of finance such as convertible bonds. The simplifying assumption that the beta of debt is zero will also lead to inaccuracy in the calculated value of the project-specific discount rate.
One disadvantage in using the CAPM in investment appraisal is that the assumption of a single period time horizon is at odds with the multi-period nature of investment appraisal.
While CAPM variables can be assumed constant in successive future
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