Respond to…
Explain how the CAPM assists in measuring both risk and return.
There is always some level of risk when you invest in something. The CAPM helps to calculate investment risk and what return on investment an investor should expect. It assists in measuring both risk and return via a mathh design to generate a percentage illustration of the risk for an investment. It assumes that financiers want a risk free investment and requests larger rates of return based on the anticipated risk. ( Byrd, Hickman & McPherson, 2013).
Explain how the CAPM assists in calculating the weighted average costs of capital (WACC) and its components.
The WACC blends costs of all the capital a company has across a variety of capital producing sources. The CAPM helps in the WACC calculation because it usually calculates the cost of equity.
Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.
According to Mullins (1982), managers may have trouble because the simple model may not be a satisfactory account of all of the actions of the financial market. Estimates of the future, risk-free rate, and expected rate on the market is susceptible to error. Mullins also claims that there is a set of problems that are exclusive to corporate finance applications of CAPM.
Identify the benefits and drawbacks of using the CAPM.
According to ACCA Global, there are at least four benefits of CAPM. 1) It considers only logical risk. 2) It produces a theoretically-derived relationship between required return and logical risk. 3) It is usually viewed as a much better method for completing the cost of equity than the dividend growth model since it takes into account a company’s level of logical risk. 4) It is obviously superior to the WACC in providing discount rates for use in investment appraisals.
References
ACCA Global CAPM: Theory, Advantages, and Disadvantages. Retrieved from https://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/CAPM-theory.html
Byrd, J., Hickman, K., & McPherson, M. (2013). Managerial finance. [Electronic version]. San Diego, CA: Bridgepoint Education, Inc.
Mullins, D.W. (1982, January). Does the Capital Asset Pricing Model work? Harvard Business Review. Retrieved November 9, 2016 http://hbr.org/1982/01/does-the-capital-asset-pricing-model-work
Respond to…
Explain how the CAPM assists in measuring both risk and return.
The ability to be competitive and profitable requires a certain amount of risk. The capital asset pricing model (CAPM), provides managers the capability to measure risk and its association with an asset and its expected return (Byrd, Hickman & McPherson, 2013). CAPM assists in measuring both risk and return by categorizing risk into two categories; systematic and unsystematic risk. Investors use these categories to determine whether an investment can be or cannot be mitigated. Ultimately, providing a measurement of risk capital and an estimated market risk or return curve.
Explain how the CAPM assists in calculating the weighted average costs of capital (WACC) and its components.
The weighted average costs of capital (WACC) is an average expected rate a company pays it security holders to finance their assets (Henderson, 1979). The WACC is often used by investors to determine the investment ability of a company. The CAPM assists in calculating WACC by calculating the cost of equity that is essentially needed in the calculation of WACC.
Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.
While commonly used, the CAPM is a method that relies on assumptions that are unrealistic to the actual occurrences of the market. For instance, the model assumes that the volatility of the market and transaction are low. However, that is not the case of the market and fees can change daily. Unfortunately, this causes many managers to have difficulties with the concept because it works under the premise that everyone is going to buy and sell in the same manner, and share the same risk, which is not the case. For example, one manager’s strategy maybe could be built on the principle that it is more profitable to buy when prices are at the lowest, when another may find this the least profitable strategy.
Identify the benefits and drawbacks of using the CAPM.
There are benefits and disadvantages to the use of the CAPM. For instance, the CAPM can be very beneficial in that it offers a simplistic calculation that can provide a variety of risk evaluative outcomes of the rate of return. Additionally, investor tend to use CAPM because is allows them to eliminate diversifiable risk by holding a large amount of different stocks (Byrd, Hickman & McPherson, 2013). However, the drawbacks to the use of the CAPM is that it relies on an unrealistic assumption of a risk-free rate, which can result in a lower return that what the model actually calculated.
Reference:
Byrd, J., Hickman, K., & McPherson, M. (2013). Managerial Finance [Electronic version]. Retrieved from https://content.ashford.edu/
Henderson, G.V. (1979). In defense of the weighted average cost of capital. Financial Management. 8(3), 57. Retrieved from https://search.proquest-com.proxy-library.ashford.edu/docview/205241443?accountid=32521