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What are the advantages and disadvantages of capital asset pricing model over portfolio theory?

Craig Stewart

in Student Loans

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Kaitlin Dean on October 25, 2018

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: 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 return and systematic risk which has been subject to frequent empirical research and testing. He is generally seen as a better method of calculating the cost of capital that the model of growth of dividends (DGM) in that it explicitly takes into account a company's level of systematic risk relative to the stock market as a whole. DISADVANTAGES OF the CAPM The CAPM suffers from a number of disadvantages and limitations that should be taken into account 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 performance short term Government debt, which is used as a proxy for the risk-free rate of return, is not fixed, but changes daily according to the economic circumstances. Short-term average value can be used to smooth this volatility. Find a value for the ERP is more difficult. The return of a stock market is the sum of the average of the 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 the fall in the price of the shares exceeds the dividend yield. Therefore, it is usual to use 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, the uncertainty about the exact ERP value introduces uncertainty in the calculated value for the return. Beta values are now calculated and published regularly for all stock exchange-traded companies. The problem here is that the uncertainty in the value of the expected return because the value of beta is not constant, but changes over time. Using the CAPM in the investment appraisal of the Problems may arise when using the CAPM to calculate a project specific discount rate. For example, one 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 extricated from the company's equity beta. One way to do this is to treat the equity beta as an average of the betas of the different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, the information on the 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 of the information that may not be easily available. Some companies have complex capital structures with many different sources of funding. Other companies may have a 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 the inaccuracy in the calculated value of the project-specific discount rate. A 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 valuation of the investment. While CAPM variables can be assumed constant in successive future periods, experience indicates that this is not true in reality.


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