The Capital Assets Pricing Model can be best described as a finance tool that can be used to derive the cost of capital of a company. It is a tool extensively used by companies to come up with the cost of capital for their equity and debt instruments. This tool is also used by investors to check out the expected rate of return of an investment.
Capital Assets Pricing Model defines the linear relationship between the required rates of return on investment. It determines whether that is for a company or an individual investor, and the systematic risk involved with the investment. Systematic risk, also known as market risk, is the risk that applies to the market as a whole and not the specific project or investment being appraised.
It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM). It is because it explicitly considers a company’s level of systematic risk relative to the stock market as a whole. Investors look forward to getting compensated for taking risks and investing their time in the value of money. The risk-free rate in the CAPM formula accounts for the time value of money. The other components of the CAPM formula account for the investor taking on additional risk.
The beta of a potential investment is a measure of how much risk the investment will add to a portfolio that looks like the market. If a stock is riskier than the market, it will have a beta greater than one. If a stock has a beta of less than one, the formula assumes it will reduce the risk of a portfolio. A stock’s beta is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate.
The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return. CAPM has numerous advantages. It would not be wrong to say that it is a much better tool such as the Dividend Discount Model or the Discounted Cash Flows model and has its advantages.
Advantages of Capital Asset Pricing Model:
It Provides A Risk Premium Formula To Investors:
The Capital Asset Pricing Model helps the investors to take the risk premium of investment into consideration and use it for making decisions as they move forward. To understand it better, it is important to know how the required rate of return on investment is calculated using the Capital Asset Pricing Model. The formula to calculate the required rate of return under this model is as follows: Required rate of return = Risk-free rate of return + Risk premium
The risk premium is the expected return on an investment in excess of the risk-free rate of return. Risk premium takes into consideration the systematic risk of an investment. As the risk premium of investment allows investors or companies to determine the value of return for the risk they are taking, the risk premium will be high for start-up companies and relatively lower for established companies.
The Best Model For Valuing Investment:
The Capital Asset Pricing Model is widely used by companies and investors for valuing investments. It is a great tool that is mostly used for its simplicity of usage and understandability, making it easy for investors to evaluate financial details. Not only this, but analysts and experts use the Capital Asset Pricing Model to give their opinions on different investments due to its accuracy for risky investments. Investors who have knowledge of the model and know how to use it can easily obtain expert opinions on any stock of their liking.
Simple and Easy Usage:
Another advantage of the Capital Asset Pricing Model is its easy usage as compared to other models that calculate the rate of return of an investment. It does not require investors to go through the complicated concepts such as the time value of money concept that is used in other models such as the Discounted Cash Flows model and they can easily come up with the information they require to move forward. In addition to this, the Capital Asset Pricing Model can be used for evaluating many different scenarios or probabilities as the rate of returns enables the investors to make better decisions.
Accuracy Regarding Returns on Investment:
The best thing about using CAPM is that while it makes some assumptions when calculating the rate of return of investment, these results are quite accurate. Investment is a risky business and it does not always provide expected results but CAPM delivers more accurate and reliable results than any other models such as the Dividend Discount Model or the Discounted Cash Flows model. It would not be wrong to say that Capital Asset Pricing Model is many experts’ and analysts’ tool of choice for calculating the rate of return on risky investments.
Disregards Unsystematic Risk:
The Capital Asset Pricing Model assumes that investors hold a diversified portfolio of investments. Thus, any unsystematic risk, the risk that is specific to an investment or industry, is disregarded and eliminated. Also, it only leaves investors to deal with only systematic risks; risks that are not specific to an investment or industry, and help them make better decisions that take them on the road to success.
The Capital Asset Pricing Model is fast becoming the most preferred financial tool for investors, experts, and analysts for investment appraisal. Despite the concerns that the experts have regarding the CAPM, the formula is popular and widely used by investors because it is simple and allows for easy comparisons of investment alternatives. It helps investors take into consideration the risk premium and systematic risks of investments while eliminating unsystematic risk. This makes it a superior tool over others for appraising risky investments and its easy usage and accurate results make it the right choice.
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