CAPM is core utility in financial modelling and the weighted average cost of capital (WACC). It also helps in calculating the net present value of future cash flows, in turn, allowing us to find the enterprise value. As most investors have a diversified portfolio, the unsystematic risk is eliminated and only systematic risk is left which is considered by this model. Also, it provides better discount rates than the WACC and is a better method to calculate the cost of equity.
The CAPM describes a relationship between the risk of the investment and the expected returns. It shows that the expected return of an investment is equal to the risk-free security and a risk premium. According to the model, if the expected returns exceed or are less than the addition of risk-free rate and a risk premium then the investment should not be made. It uses the beta of the security, which depicts the volatility of the returns of the asset.
Expected rate of return = Risk-free rate of return + (Beta*Market Risk Premium)
Er = Rf + B*(Rm-Rf)
Er = Expected return of the security
Rf = Risk-free rate of return
B = Beta value of the security
Rm = Expected return of the market
Market Risk Premium = Rm-Rf
The formula is based on the systematic risk and the risk premium by which the investors should be compensated. This risk premium is greater than the risk-free rate and is expected to be greater when the security has high risk.
Furthermore, the expected return is the estimated long term return the security is expected to give.
The risk-free rate of return is basically the return a bond gives in that particular country. It is generally taken as the rate of a 10-year bond.
Beta is the stock’s risk which is calculated by the fluctuations of the market prices of the stocks. It gives the percentage of volatility against the market average. If it is equal to 1 then the expected return is the same as the return in the market.
Market Risk Premium is the return which an investor gets over and above the risk-free returns. This is basically to compensate the investor who invests in high-risk asset classes.
The model has been criticized for not being based on reality due to certain assumptions it makes while calculating the expected returns. These assumptions are:
i. All investors hold diversified portfolios – Since it assumes that investors hold an only diversified portfolio, the resultant does not consider the unsystematic risk. It only considers the systematic diversifiable risk.
ii. Single holding period – This assumes that the period of holding of all securities in comparison have the same holding period. One year is the standard holding period which CAPM considers.
iii. Perfect capital market – CAPM assumes that all investors have the perfect information that they require to invest. Also, there are no taxes and no transaction costs thus expecting the same returns.
It also assumes that there are a large number of buyers and sellers in the market who are risk-averse and rational.
Assume that the risk-free return is 6% for India and the average expected return of the S&P 500 is 14%. The beta value of XYZ company’s stock is said to be 1.5 and the overall beta value of the market is 1.
Expected rate of return = Rf + B (Rm-Rf)
= 6 + 1.5 (14-6)
Here the risk of the stock is higher than the market risk, which means the risk premium should be higher than the risk-free rate.
The expected rate of return for the stock of XYZ Ltd. should be 18%. If the investor feels that the returns will not be 18% or more than they should not invest in this stock.
CAPM because of its assumptions has been facing criticisms but it stands through these criticisms as it is very useful in financial management.