Capital asset pricing model

Definition

The capital asset pricing model (CAPM) is a financial formula that establishes a relationship between the expected return of an investment and its risk as measured by beta. It is instrumental in determining the appropriate required rate of return on an asset based on its systematic risk in relation to the overall market. CAPM helps investors assess whether an asset is fairly valued and is widely used in investment analysis and capital budgeting decisions.

5 Must Know Facts For Your Next Test

1. CAPM calculates expected return using the formula: Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate).
2. The model assumes that investors hold diversified portfolios, which eliminates unsystematic risk and focuses solely on systematic risk.
3. CAPM is widely used in capital budgeting to evaluate the feasibility of investment projects by estimating their expected returns against their risks.
4. The market risk premium, represented by (Market Return - Risk-Free Rate), is crucial in determining the additional return required for taking on extra risk.
5. Limitations of CAPM include assumptions like market efficiency and investor rationality, which may not always hold true in real-world scenarios.

Review Questions

• How does the capital asset pricing model assist in determining the required rate of return for an investment?
  • The capital asset pricing model helps determine the required rate of return by linking it to the investment's systematic risk as measured by beta. By using the formula Expected Return = Risk-Free Rate + Beta * (Market Return - Risk-Free Rate), investors can calculate what return they should expect for taking on a specific level of risk. This allows them to evaluate whether an investment is worth pursuing compared to its inherent risks.
• In what ways does CAPM influence decision-making during the capital budgeting process for new projects?
  • CAPM influences decision-making in capital budgeting by providing a framework to assess expected returns on new projects relative to their risks. By applying CAPM, firms can estimate the cost of equity for potential investments and ensure that expected returns exceed this cost, making projects more attractive. This evaluation helps prioritize investments that align with the firm's risk tolerance and financial goals, ultimately leading to better resource allocation.
• Critically evaluate the assumptions of CAPM and discuss their implications for its application in real-world finance.
  • The assumptions of CAPM, such as market efficiency and investor rationality, create a foundation for its theoretical validity but can also limit its practical application. In reality, markets are often influenced by irrational behavior and external factors that cause deviations from these assumptions. This leads to potential inaccuracies in estimating expected returns, making it crucial for investors to consider additional factors and alternative models when applying CAPM to their investment decisions or capital budgeting processes.

Related terms

Beta:

A measure of a stock's volatility in relation to the overall market, indicating its systematic risk.

Expected Return:

The anticipated return on an investment based on its historical performance and risk factors.

Risk-Free Rate: The return on an investment with zero risk, often represented by government bonds, used as a benchmark in CAPM.