In finance, one of the most important things to remember is that return is a

function of risk. This means that the more risk you take, the higher your potential
return should be to offset your increased chance for loss.
One tool that finance professionals use to calculate the return that an investment
should bring is the Capital Asset Pricing Model which we will refer to as CAPM for
this lesson. CAPM calculates a required return based on a risk measurement. To
do this, the model relies on a risk multiplier called the beta coefficient, which we
will discuss later in this lesson.
Like all financial models, the CAPM depends on certain assumptions. Originally
there were nine assumptions, although more recent work in financial theory has
relaxed these rules somewhat. The original assumptions were:

1. Investors are wealth maximizers who select investments based on expected

return and standard deviation.
2. Investors can borrow or lend unlimited amounts at a risk-free (or zero risk)
rate.
3. There are no restrictions on short sales (selling securities that you don't yet
own) of any financial asset.
4. All investors have the same expectations related to the market.
5. All financial assets are fully divisible (you can buy and sell as much or as
little as you like) and can be sold at any time at the market price.
6. There are no transaction costs.
7. There are no taxes.
8. No investor's activities can influence market prices.
9. The quantities of all financial assets are given and fixed.

Obviously, some of these assumptions are not valid in the real world (most
notably no transaction costs or taxes), but CAPM still works well, and results can
be adjusted to overcome some of these assumptions.

The Beta Coefficient

Before we can use the CAPM formula, we need to understand its risk
measurement factor known as the beta coefficient. By definition, the securities
market as a whole has a beta coefficient of 1.0. The beta coefficients of individual
companies are calculated relative to the market's beta. A beta above 1.0 implies
a higher risk than the market average, and a beta below1.0 implies less risk than
the market average. Most companies' betas fall between 0.75 and 1.50, but any
number is possible, including negative numbers; a negative beta would be highly
unlikely, however, since it would imply less risk than a 'risk free' investment.
For actual use, the beta coefficients of most companies can be found on financial
websites as well as in electronic publications. You can do a quick search to find
companies' beta coefficients.

Formula and Examples

The CAPM formula is sometimes called the Security Market Line formula and
consists of the following equation:
r* = kRF + b(kM - kRF)
It is basically the equation of a line, where:
r* = required return
kRF = the risk-free rate
kM = the average market return
b = the beta coefficient of the security
You will sometimes see the kM - kRF term replaced by kMRP. kMRP (the market
risk premium) = kM - kRF, so this is just a shortcut when the market risk premium
has already been calculated. Remember again that the beta of the market is 1.0,
so kMRP is just the additional return required from the market as a whole.
We should also take a moment to talk about the risk-free rate, kRF. Investments
are subject to many risks that may come from the economy, the nature of the
market, the industry in which a company operates, or the company itself. Of
these risk factors, the only one that is universal is the risk that inflation will
decrease an investor's purchasing power. In theory, the risk-free rate is the return
that an investment with no risks should earn, but in practice it includes the ever-
present risk of inflation.
Let's calculate a couple of required returns using fictional companies X and Z to
see how this works. For our calculations, we will use the return on Company X as
the risk-free rate and the 1-year return on Company Z as the market return. Let's
hypothetically use beta coefficients for Company X and Company Z as 0.10% and
20.63%, respectively. Hypothetically, let's also provide Company R, S, and T with
these current beta coefficients:

An economic theory that describes the relationship

between risk and expected return, and serves as a model for the pricing
of risky securities. The CAPM asserts that the only risk that is priced by
rational investors is systematic risk, because that risk cannot be
eliminated by diversification. The CAPM says that the expected return of
a security or a portfolio is equal to the rate on a risk-free security plus a
risk premium multiplied by the asset's systematic risk. Theory was
invented by William Sharpe (1964) and John Lintner (1965). The early
work of Jack Treynor is was also instrumental in the development of this
model.
Nearby Terms

The capital asset pricing model asserts that the investor should
be compensated in two ways: Time value of money and
the Risk. The time value of money means, the value of money
today worth more than the value of the same amount in the
future. Thus, an investor is compensated for employing a certain
sum of money in a particular investment over a period of time.
 The Time Value of money is represented by “rf”i.e. A risk-free
rate in the formula of CAPM.

The second part of the formula comprises of a risk; an investor

should be compensated for the additional risk that he bears by
placing his funds in a particular investment. The Risk is
represented by beta (β) that compares the returns on asset for a
particular time period against the market premium (Rm-Rf).

Assumptions of Capital Asset Pricing Model

1. Investors are risk averse, i.e. they place funds in the less risky
investments.
2. All investors have the same expectations from the market and
are well informed.
3. No investor is big enough to influence the price of the securities.
4. The market is perfect: There are no taxes, no transaction costs,
securities are completely divisible, and the market is competitive.
5. Investors can borrow and lend unlimited amounts at a risk-free
rate (zero bonds).

Generally, the capital asset pricing model helps in the pricing of

risky securities, such that the implications of risk and the amount
of risk premium necessary for the compensation can be
ascertained.

CAPM states the price of a stock is tied to two variables: the time value of
money, and the risk of the stock itself. When we look at some of the
formulas used in the CAPM later, we'll see that the time value of money is
represented by the risk-free rate of interest or rf.


When measuring the risk of the stock itself, the capital asset pricing model
explains that risk in terms that are relative to the overall stock market risk.
Fortunately, this is exactly what a stock's beta measures.
To figure out the expected rate of return of a particular stock, the CAPM
formula only requires three variables:

 rf = which is equal to the risk-free rate of an investment

 rm = which is equal to the overall stock market risk
 B = which is equal to the stock's beta

The calculation provided by the CAPM helps investors determine their

return by using a formula that explains the relationship between expected
return and risk:
Expected Rate of Return = r = rf + B (rm - rf)
Where:

 rf = The risk-free interest rate is what an investor would expect to

receive from a risk-free investment. Typically, U.S. Treasury Bills are
used when examining U.S. dollars, and German Government bills are
used for the Euro.
 B = A stock beta is used to mathematically describe the relationship
between the movements of an individual stock versus the entire
market. Investors can then use a stock's beta to measure the risk of
a security.
 rm = The expected market return is the return the investor would
expect to receive from a broad stock market indicator such as the
S&P 500 Index. For example, over the last 17 years or so, the S&P
500 has yielded investors an average annual return of around 8.10%.

So what exactly does the CAPM formula tell us? The formula states the
expected return of a stock is equal to the risk-free rate of interest, plus the
risk associated with all common stocks (market premium risk), adjusted for
the risk of the common stock being examined. In other words, the investor
can expect a rate of return on an asset that compensates them for both the
risk-free rate of interest, the stock market's risk, and the stock's individual
risk.
Calculating Expected Returns
Individuals interested in running through calculations using the CAPM
approach, can use our Capital Asset Pricing Model Calculator. That
calculator provides guidance on finding a stock's beta online, information
on the risk-free rate of interest, as well as the expected market return.
By using the above-mentioned information, the calculator can figure out the
expected stock market premium, in addition to the expected rate of return
for a capital asset (a share of common stock in this example).
CAPM versus Arbitrage Pricing Theory
With the advent of modern computers, and the complex relationships they
can examine, it is surprising there hasn't been more interest in
the Arbitrage Pricing Theory or APT. The approach was first outlined by
Stephen Ross in his publication The Arbitrage Theory of Capital Asset
Pricing, which appeared in the Journal of Economics in December 1976.
While the CAPM builds on the concept of investors constructing efficient
portfolios, the arbitrage pricing theory attempts to explain the expected
return on a stock in terms of other factors. APT differs from CAPM in that it
assumes that a stock's return depends on multiple factors, as explained by
the APT formula below:
Expected Return = rf + b1 x (factor 1) + b2 x (factor 2)... + bn x (factor n)
Where:

 b = the sensitivity of the stock to each factor

 factor = the risk premium associated with each variable

The APT is different than CAPM in that it doesn't attempt to identify each of
the factors for a given stock. For example, the price of oil might be one
factor that applies to ExxonMobil but not to Colgate Palmolive.
While the entire APT approach provides a great deal of analytical "leeway,"
it is this same lack of specificity that makes the CAPM approach easier to
understand and calculate

One of the most simple and highly revered model in finance, Capital Asset Pricing
Model (CAPM) is used to estimate the required rate of return on a risky asset.

Mathematical Representation:
It is given by a simple linear equation as:

E(Ra) = RFR + β [E(Rm) – RFR]

where,
E(Ra) = expected rate of return on a risky asset.

RFR = risk free rate

β = beta

E(Rm) = Expected market return

Post-mortem of the equation:

Equation states that expected rate of return on given risky asset E(Ra) is equal to
the sum of risk-free rate (RFR) and beta(β) adjusted market risk
premium ([E(Rm) – RFR]).
Before dissecting the different components of CAPM, let’s first plot this on graph.

CAPM equation is that of a straight line (y = mx + c),

where y = E(Ra), c= RFR, x = β and m = [E(Rm) – RFR]
Green line represents the CAPM equation. This line is known as Security Market
Line (SML).

Also note that when β = 1, then E(Ra) = E(Rm) and the portfolio is known as
market portfolio.

Assumptions of CAPM:

 CAPM is based on REM (Rational Economic Man) concept of traditional

finance. It assumes that all investors are rational and risk-averse, holding a
diversified portfolio with an aim to maximize economic utilities.
 All investors have a portfolio which is a combination of market portfolio and
the risk-free asset, adjusted to their risk-averse appetite.
 Unlimited lending and borrowing can be done at the risk free rate.
 Transaction, administrative and other overhead costs are zero.
  Most importantly, model assumes that expected return on a risky asset can
be determined as a function of its systematic risk only.

Components of CAPM explained:

 First component of CAPM is RFR i.e. risk free rate. It is, as the name
suggests, the return that you can earn risk free. Though no asses is risk free
but U.S. Treasury bills and bonds are generally used as a proxy for the risk
free rate. RFR to be used depends on the duration of risky asset under
consideration, using long term bonds for longer risky assets and so forth.
 Second component is E(Rm) i.e. expected market return: It determines the
expected return of the market as a whole and can be based on past returns or
expected future returns. There are various ways to determine expected
market return.
 E(Rm) – RFR is also known as market risk premium i.e. how much did
market as a whole return above the risk free rate.
 β i.e. Beta : This is the most crucial of all the components and measures the
systematic risk of holding a risky asset.Basically risk can be divided into two
components: Unsystematic risk and systematic risk. Unsystematic risk also
known as idiosyncratic risk refers to risk associated with individual
assets.Ideally, we can reduce our unsystematic risk by holding a diversified
portfolio. However, systematic risk refers to the risk that is common to all
securities i.e. market risk. This cannot be reduced by holding a diversified
portfolio and hence investor must be paid for exposing himself/herself to this
risk. β measures this systematic risk and thus is considered while calculating
the expected return on the risky asset.

If β > 1, it implies that asset is riskier than the market as a whole and thus
E(Ra) > E(Rm)
If β < 1, it implies that asset is less risky than the market as a whole and thus
E(Ra) < E(Rm)

β is defined by the formula:

 where
Cov(i,mkt) = covariance between the asset’s return and return on the market
σ_mkt^2 = standard deviation of market

Thus β is the standardized measure of systematic risk.

Application of CAPM:
As explained, CAPM is basically used to calculate the expected return on any risky
asset.

This is really helpful when evaluating if an asset is fairly priced, overvalued or

undervalued.

Fairly Valued:
If E(Ra) = R , then the asset is fairly valued

Overvalued:
If E(Ra) > R, then the asses is said to be overvalued.

Undervalued:
If E(R) < R, then the asset is said to be undervalued.

Implications of categorizing an asset as fairly valued, undervalued or overvalued:

If an asset is overvalued, then sell (or short sell) it as it is expected to decrease in

value.
If an asset is undervalued, then buy it as it is expected to increase in value.
If an asset is fairly valued, then buy, sell or ignore. Doesn’t really matter.

Problems with CAPM:

 One of the main issues with CAPM, as is with any traditional model, is the
assumptions that investors are REM (Rational and Economic Men). Rarely
are the investors rational and rarely does CAPM map perfectly in the real
world.
  It assumes that risk of an asset is solely dependent on beta (market risk). All
other factors are ignored.
 Unsystematic risk is assumed to be compensated by holding a well-
diversified portfolio. Hardly this is the case.
 Assumes there is no taxes, transaction or any other overhead cost. Nothing
comes for free.
 Assumes that RFR exists. Remember we use treasury bills as proxy for RFR.
Nothing is risk-free in this world.

The Bottom Line

The capital asset pricing model is by no means a perfect theory. But the spirit of
CAPM is correct. It provides a usable measure of risk that helps investors
determine what return they deserve for putting their money at risk.

The capital asset pricing model (CAPM) is a mathematical model that

seeks to explain the relationship between risk and return in a
rational equilibrium market. Developed by academia, the CAPM has been
employed in applications ranging from corporate capital budgeting to
setting public utility rates. The CAPM provides much of the justification for
the trend toward passive investing in large index mutual funds.
William Sharpe, John Lintner, and Jan Mossin simultaneously and
independently developed the CAPM. Their research appeared in three
different, highly respected journals during the period of 1964-66. When the
CAPM was first introduced, the investment community viewed the new
model with suspicion, since it seemed to indicate that professional
investment management was largely a waste of time. It was nearly a
decade before investment professionals began to view the CAPM as an
important tool in helping investors understand risk.
The key element of the model is that it separates the risk affecting an
asset's return into two categories. The first type is called unsystematic, or
company-specific, risk. The long-term average returns for this kind of risk
should be zero. The second kind of risk, called systematic risk, is due to
general economic uncertainty. The CAPM states that the return on assets
should, on average, equal the yield on a risk-free bond held over that time
plus a premium proportional to the amount of systematic risk
the stock possesses.

RISK AND THE CAPM

The treatment of risk in the CAPM refines the notions of systematic and
unsystematic risk developed by Harry M. Markowitz in the 1950s.
Unsystematic risk is the risk to an asset's value caused by factors that are
specific to an organization, such as changes in senior management or
product lines. For example, specific senior employees may make good or
bad decisions or the same type of manufacturing equipment utilized may
have different reliabilities at two different sites. In general, unsystematic risk
is present due to the fact that every company is endowed with a unique
collection of assets, ideas, personnel, etc., whose aggregate productivity
may vary.
A fundamental principle of modern portfolio theory is that unsystematic risk
can be mitigated through diversification. That is, by holding many different
assets, random fluctuations in the value of one will be offset by opposite
fluctuations in another. For example, if one fast food company makes a bad
policy decision, its lost customers will go to a different fast food
establishment. The investor in both companies will find that the losses in
the former investment are balanced by gains in the latter.
Systematic risk is risk that cannot be removed by diversification. This risk
represents the variation in an asset's value caused by unpredictable
economic movements. This type of risk represents the necessary risk that
owners of a firm must accept when launching an enterprise. Regardless of
product quality or executive ability, a firm's profitability will be influenced by
economic trends.
In the capital asset pricing model, the risk associated with an asset is
measured in relationship to the risk of the market as a whole. This is
expressed as the stock's a (beta), or correlation to the market average. The
returns of an asset where 13 = I will, on average, move equally with the
returns of the overall market. Assets with β < I will display average
movements in return less extreme than the overall market, while those with
a > I will show return fluctuations greater than the overall market.
Mathematically, (is defined as the covariance of an asset's returns divided
by the variance of the market's return. The market's return is most often
represented by an equity index, such as Standard and Poor's 500 or
the Wiltshire 5000. These large equity indexes are commonly viewed as
bench-marks against which a securities performance is judged.
The preceding paragraphs are summarized in the following equation:

Where:
K i = the required return on asset i
R f = risk-free rate of return on a U.S. Treasury bill
β i = beta coefficient or index of non-diversifiable risk for asset i
k m = the return on the market portfolio of assets

ASSET RETURNS IN THE CAPM

The CAPM models return to an asset by the following three guidelines.
First, all assets must have an expected return of at least the return to a
risk-free bond (except for rare assets with (3 < 0, which will be discussed
below). The rationale is that any risky asset must be expected to return at
least as much as one without risk or there would be no incentive for anyone
to hold the risky asset.
Second, there is no expected return to taking unsystematic risk since it may
easily be avoided. Diversification is simple, does not affect
the economics of the assets being held, and only helps the investors
holding the assets. Therefore, there is no compensation inherent in the
model for accepting this needless risk by choosing to hold an asset in
isolation.
Finally, assets that are subject to systematic risk are expected to earn a
return higher than the risk-free rate. This premium should be incremental to
the risk free rate by an amount proportional to the amount of this risk
present in the asset. This risk cannot be diversified away and must be
borne by the investor if the assets are to be financed and employed
productively. The higher the systematic risk, the higher the average long-
term return must be for the holder to be willing to accept the risk.
The market risk premium was reported by R. Ibbotsen and R. Sinquefield to
average about 6.1 percent. This amount is modified by the (3 which scales
it up or down depending on the asset's sensitivity to market movements.
Interestingly, some assets have a negative premium. This is because their
(3 is less than zero, meaning the asset's expected return is less than the
risk-free rate. Assets with negative returns are those that
actually hedge against general economic risk, doing well when the
economy performs poorly. Examples of this type of asset are precious
metals.
The Security Market Line (SML), which has the following equation, may
summarize the preceding discussion:

Where:
E[R i ] is the expected return to asset i
R f is the risk free rate of return
β im is asset i 's market Beta
E [ R m — R f ] is the expected market risk premium
Graphically, the SML may be represented by the graph in Figure 1.

ASSUMPTIONS OF THE CAPM

The CAPM draws conclusions from a variety of assumptions. Some are
vital to its premise, others cause only minor changes if they are untrue.
Since the early 1970s much research into the plausibility and effects of
weakness in these assumptions has been conducted by academia. The
assumptions that form the basis for the CAPM are:

 Investors measure asset risk by the variance of its return over future
periods. All other measures of risk are unimportant.
  Investors always desire more return to less, and they are risk averse;
that is, they will avoid risk if all else is equal.
 There are no restrictions on the borrowing and lending of money at
the risk-free rate of interest.
 All possible investments are traded in the market and are available to
everyone, the assets are infinitely devisable, and there are no
restrictions on short selling.
 The market is perfectly efficient. That is, every investor receives and
understands the same information, processes it accurately, and
trades without cost. There is no consideration of the effects of
taxation.

EMPIRICAL TESTS OF THE CAPM

Two early tests of the CAPM revealed that the model was conceptually
sound except that the Security Market Line intercept was estimated to be
approximately 3 to 4 percent higher than the risk-free rate. This is
consistent with a CAPM model where money cannot actually be borrowed
at the risk-free rate.
R. Roll wrote a famous article in which he argued that tests of the CAPM
are inherently impossible. The article is quite technical, but its basic point is
the following. Since no one can observe the true market portfolio, only a
proxy index, and since no one can actually observe expected returns, only
average realized ones, it is impossible to know whether the correct
relationship is actually being tested.
More recent tests of the CAPM show that there are many apparent
shortcomings of the strict interpretation of the model. Examples include
seasonal fluctuations (such as unusually high returns for some companies
in January), and different average returns on Friday and Monday from that
of other days of the week. In addition, some analysts have argued that
stock returns are more closely related to the book value and total variability
of the stock, rather than a beta calculated using a market index.
Others argue that many apparent inconsistencies can arise in the CAPM
because a capital weighted index (such as the S&P 500) may not be an
appropriate proxy for the market portfolio. This is especially true if the
assumptions regarding short sales and risk free borrowing are violated.

EXTENSIONS OF THE CAPM

In 1976, S. Ross published a different model, the Arbitrage Pricing Theory
(APT), which avoids the need for specifying a market portfolio. Although
this model is generally believed to be more powerful than the CAPM, it is
less intuitive and more difficult to implement. In the APT, an asset's return
is related to multiple economic factors instead of the market portfolio.
Another attempt to modify the CAPM involves adjusting it for temporality.
With temporal modeling, investors consider the consequences of decisions
over multiple periods, instead of over the next period only, as the CAPM
assumes. The resulting Consumption Capital Asset Pricing Model
(CCAPM) is much more complex than its non-temporal counterpart. It has
been shown to work successfully in situations where the normal CAPM has
failed, most notably for forward exchange rates and for futures markets.
Many other adaptations of the CAPM are in use. It is a validation of the
widespread applicability of the CAPM that so many individuals have
improved, transformed, or modified it to fit specific situations.

APPLYING THE CAPM

Despite limitations, the Capital Asset Pricing Model remains the best
illustration of long-term tradeoffs between risk and return in the financial
markets. Although very few investors actually use the CAPM without
modification, its principles are very valuable, and may function as a
sufficient guide for the average long-term investor.
These principles may be stated as:
 1. Diversify—there is no compensation for unsystematic risk.
2. Hold long term—do not worry about timing when to get in or out of the
market.
3. To earn a higher return, take on more systematic risk. The more
stocks one holds that are sensitive to the business cycle the more
average return the portfolio will receive. For shorter term, or more
sophisticated investing, other models have been developed.
However, unless the model is based on market inefficiencies, or
obtaining superior information, it will still have the CAPM basic tenets
at its center.

CAPM FORMULA
The linear relationship between the return required on an investment
(whether in stock market securities or in business operations) and its
systematic risk is represented by the CAPM formula, which is given in
the Paper F9 Formulae Sheet:

The CAPM is an important area of financial management. In fact, it

has even been suggested that finance only became ‘a fully-fledged,
scientific discipline’ when William Sharpe published his derivation of
the CAPM in 1986 (Megginson WL, Corporate Finance Theory,
Addison-Wesley, p10, 1996).

CAPM ASSUMPTIONS
The CAPM is often criticised as being unrealistic because of the
assumptions on which it 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, 2007, Corporate
Finance: Principles and Practice, 4th edition, FT Prentice Hall, pp222–
3):

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 removed and can be ignored.

Single-period transaction horizon

A standardised holding period is assumed by the CAPM in order to
make comparable the returns on different securities. 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 (see Figure 1). The
SML is a graphical representation of the CAPM formula.

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.

For example, real-world capital markets are clearly not perfect. 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, as a result, for their
returns not to plot on to 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, in reality, it is not possible for

investors to 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 the slope of the SML is shallower in practice
than in theory.

Overall, it seems reasonable to conclude that while the assumptions

of the CAPM represent an idealised rather than real-world view, there
is a strong possibility, in reality, of a linear relationship existing
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 a number of
restrictive assumptions are met. These assumptions are that:

 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 essentially state 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 (Project-specific discount rates,
Student Accountant, April 2008).

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 was used as the discount rate,

because the internal rate of return (IRR) of the project is less than that
of the WACC. This investment decision is incorrect, however, since
project A would be accepted if a CAPM - derived project-specific
discount rate were 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, pp252–3).

ADVANTAGES OF THE CAPM

The CAPM has several advantages over other methods of calculating
required return, explaining why it has remained 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 generates 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 takes into account 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.

DISADVANTAGES OF THE CAPM

The CAPM suffers from a number of disadvantages and limitations
that should be noted in a balanced discussion of this important
theoretical model.

Assigning values to CAPM variables

In order to use the CAPM, values need to be assigned to the risk-free
rate of return, the return on the market, or the equity risk premium
(ERP), and the equity beta.

The yield on short-term Government debt, which is used as a

substitute for the risk-free rate of return, is not fixed but changes on a
daily basis according to economic circumstances. A short-term
average value can be used in order to smooth out this volatility.

Finding a value for the ERP is more difficult. The return on a stock
market is the sum of the average capital gain and the average
dividend yield. In the short term, a stock market can provide a
negative rather than a positive return if the effect of falling share
prices outweighs the dividend yield. It is therefore usual to use a
long-term average value for the ERP, taken from empirical research,
but it has been found that the ERP is not stable over time. In the UK,
an ERP value of between 2% and 5% is currently seen as reasonable.
However, uncertainty about the exact ERP value introduces
uncertainty into the calculated value for the required return.

Beta values are now calculated and published regularly for all stock
exchange-listed companies. The problem here is that uncertainty
arises in the value of the expected return because the value of beta is
not constant, but changes over time.
Using the CAPM in investment appraisal
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 periods, experience
indicates that this is not true in reality.

CONCLUSION
Research has shown the CAPM to stand up well to criticism, although
attacks against it have been increasing in recent years. Until
something better presents itself, however, the CAPM remains a very
useful item in the financial management toolki