The widely used capital asset pricing model (CAPM) – when put into practice – has pros and cons.
CAPM model: an overview
The Capital Asset Pricing Model (CAPM) is a financial theory that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between the beta of an asset, the risk-free rate (generally the rate of the Treasury bills) and the risk premium of the shares, or the expected return in the market minus the free rate of risk.
me(rI)= RF + BI(me(rsubway)–RF)where:me(rI)=required return on financial assets IRF=risk-free rate of returnBI=beta value of financial asset Ime(rsubway)=average capital market return
At the heart of the model are its underlying assumptions, which many criticize for being unrealistic and which could provide the basis for some of its main drawbacks. No model is perfect, but each one should have some characteristics that make it useful and applicable.
Advantages of the CAPM model
There are numerous benefits to the CAPM application, including:
Easy to use
The CAPM is a simple calculation that can be easily tested for a variety of possible results that provide confidence around the required rates of return.
- The CAPM is a widely used profitability model that is easily calculated and stress tested.
- He is criticized for his unrealistic assumptions.
- Despite these criticisms, the CAPM provides a more useful output than the DDM or WACC models in many situations.
The assumption that investors have a diversified portfolio, similar to the market portfolio, eliminates unsystematic (specific) risk.
The CAPM takes into account systematic risk (beta), which is outside of other profitability models, such as the dividend discount model (DDM). Systematic or market risk is an important variable because it is unforeseen and, for that reason, often cannot be fully mitigated.
Variability of business and financial risk
When companies research opportunities, if the business combination and financing differ from the current business, other required performance calculations such as weighted average cost of capital (WACC) cannot be used. However, the CAPM can.
When used in conjunction with other aspects of an investment mosaic, the CAPM can provide unmatched performance data that can support or eliminate a potential investment.
Disadvantages of the CAPM model
Like many scientific models, the CAPM has its drawbacks. The main drawbacks are reflected in the inputs and assumptions of the model, which include:
Risk free rate (Rf)
The commonly accepted rate used as RF it is the yield of government securities in the short term. The problem with using this input is that performance changes daily, which creates volatility.
Return to market (Rm)
Market performance can be described as the sum of capital gains and market dividends. A problem arises when, at any given time, the market performance may be negative. As a result, a long-term market return is used to smooth the performance. Another problem is that these returns are retrospective and may not be representative of future market returns.
Ability to borrow at a risk-free rate
CAPM is based on four main assumptions, including one that reflects an unrealistic picture of the real world. This assumption, that investors can borrow and lend at a risk-free rate, is actually unattainable. Individual investors cannot borrow (or lend) at the same rate as the US government. Therefore, the required minimum return line might actually be less steep (provide a lower return) than you calculate. the model.
Determination of Project Proxy Beta
Companies that use the CAPM to evaluate an investment must find a beta version that reflects the project or investment. Often times, a proxy beta is required. However, accurately determining one to properly evaluate the project is difficult and can affect the reliability of the result.