See Also:
Cost of Capital
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of ReturnCapital Asset Pricing Model (CAPM)
The
Capital Asset Pricing Model is an equilibrium model that measures the relationship between risk and expected return of an
asset based on the asset’s sensitivity to movements in the overall stock market.
CAPM is used to price the risk of an asset or a portfolio of assets. The model is based on the idea that there are two types of risk, systematic risk and idiosyncratic risk, and that the investor should be compensated for both types of risk, as well as, the
time value of money. Systematic risk refers to market risk. Idiosyncratic risk refers to the risk of an individual asset. Time value of money refers to the difference between the present value of money and the
future value of money. The model is also used to measure the required rate of return for capital budgeting projects.
The
CAPM states that an asset’s expected return equals the risk-free rate plus a risk premium. The risk-free rate refers to the return on an investment without risk, such as a US Treasury Bond, and represents the time value of money. The risk premium represents the incremental return for investing in a risky asset. In the
CAPM, it is defined as the market premium, or the overall stock market return less the risk-free rate, multiplied by the beta of the asset. Beta is a factor that measures an asset’s sensitivity to movements in the overall stock market. According to the
CAPM, riskier assets should yield higher returns.
The CAPM FormulaExpected Return = Risk-Free Rate + Beta (Market Return - Risk-Free Rate)For example, if the risk free rate is 5%, the market return is 10%, and the stock’s beta is 2, then the expected return on the stock would be 15%.
15% = 5% + 2 (10% - 5%)
Problems with CAPMThe
Capital Asset Pricing Model is based on assumptions. First, the model assumes that a riskier asset will yield a higher return. But this is not necessarily true. A risky asset could decline in value. Second, beta is determined by historical data and the model assumes this historical data is an accurate predictor of future results. But the asset’s future volatility may not necessarily reflect its past volatility.