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CAPM:theory,advantages,anddisadvantages|F9FinancialManagement|ACCAQualification|Students|ACCAGlobal

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CAPM: THEORY, ADVANTAGES, AND


DISADVANTAGES

RELATED LINKS
StudentAccountanthubpage
RelevanttoACCAQualificationPaperF9

THECAPITALASSETPRICINGMODEL
SectionEoftheStudyGuideforPaperF9containsseveralreferencestothecapitalassetpricingmodel
(CAPM).Thisarticleisthelastinaseriesofthree,andlooksatthetheory,advantages,and
disadvantagesoftheCAPM.ThefirstarticleintroducedtheCAPManditscomponents,showedhowthe
modelcanbeusedtoestimatethecostofequity,andintroducedtheassetbetaformula.Thesecond
articlelookedatapplyingtheCAPMtocalculateaprojectspecificdiscountratetouseininvestment
appraisal.
CAPMFORMULA
Thelinearrelationshipbetweenthereturnrequiredonaninvestment(whetherinstockmarketsecurities
orinbusinessoperations)anditssystematicriskisrepresentedbytheCAPMformula,whichisgivenin
thePaperF9FormulaeSheet:

TheCAPMisanimportantareaoffinancialmanagement.Infact,ithasevenbeensuggestedthatfinance
onlybecameafullyfledged,scientificdisciplinewhenWilliamSharpepublishedhisderivationofthe
CAPMin1986(MegginsonWL,CorporateFinanceTheory,AddisonWesley,p10,1996).
CAPMASSUMPTIONS
TheCAPMisoftencriticisedasbeingunrealisticbecauseoftheassumptionsonwhichitisbased,soitis
importanttobeawareoftheseassumptionsandthereasonswhytheyarecriticised.Theassumptions
areasfollows(WatsonDandHeadA,2007,CorporateFinance:PrinciplesandPractice,4thedition,FT
PrenticeHall,pp2223):
Investorsholddiversifiedportfolios
Thisassumptionmeansthatinvestorswillonlyrequireareturnforthesystematicriskoftheirportfolios,
sinceunsystematicriskhasbeenremovedandcanbeignored.
Singleperiodtransactionhorizon
AstandardisedholdingperiodisassumedbytheCAPMinordertomakecomparablethereturnson
differentsecurities.Areturnoversixmonths,forexample,cannotbecomparedtoareturnover12
months.Aholdingperiodofoneyearisusuallyused.
Investorscanborrowandlendattheriskfreerateofreturn
Thisisanassumptionmadebyportfoliotheory,fromwhichtheCAPMwasdeveloped,andprovidesa
minimumlevelofreturnrequiredbyinvestors.Theriskfreerateofreturncorrespondstotheintersection
ofthesecuritymarketline(SML)andtheyaxis(seeFigure1).TheSMLisagraphicalrepresentationof
theCAPMformula.
Perfectcapitalmarket
Thisassumptionmeansthatallsecuritiesarevaluedcorrectlyandthattheirreturnswillplotontothe
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SML.Aperfectcapitalmarketrequiresthefollowing:thattherearenotaxesortransactioncoststhat
perfectinformationisfreelyavailabletoallinvestorswho,asaresult,havethesameexpectationsthatall
investorsareriskaverse,rationalanddesiretomaximisetheirownutilityandthattherearealarge
numberofbuyersandsellersinthemarket.

WhiletheassumptionsmadebytheCAPMallowittofocusontherelationshipbetweenreturnand
systematicrisk,theidealisedworldcreatedbytheassumptionsisnotthesameastherealworldinwhich
investmentdecisionsaremadebycompaniesandindividuals.
Forexample,realworldcapitalmarketsareclearlynotperfect.Eventhoughitcanbearguedthatwell
developedstockmarketsdo,inpractice,exhibitahighdegreeofefficiency,thereisscopeforstock
marketsecuritiestobepricedincorrectlyand,asaresult,fortheirreturnsnottoplotontotheSML.
Theassumptionofasingleperiodtransactionhorizonappearsreasonablefromarealworldperspective,
becauseeventhoughmanyinvestorsholdsecuritiesformuchlongerthanoneyear,returnsonsecurities
areusuallyquotedonanannualbasis.
Theassumptionthatinvestorsholddiversifiedportfoliosmeansthatallinvestorswanttoholdaportfolio
thatreflectsthestockmarketasawhole.Althoughitisnotpossibletoownthemarketportfolioitself,itis
quiteeasyandinexpensiveforinvestorstodiversifyawayspecificorunsystematicriskandtoconstruct
portfoliosthattrackthestockmarket.Assumingthatinvestorsareconcernedonlywithreceivingfinancial
compensationforsystematicriskseemsthereforetobequitereasonable.
Amoreseriousproblemisthat,inreality,itisnotpossibleforinvestorstoborrowattheriskfreerate(for
whichtheyieldonshortdatedGovernmentdebtistakenasaproxy).Thereasonforthisisthattherisk
associatedwithindividualinvestorsismuchhigherthanthatassociatedwiththeGovernment.This
inabilitytoborrowattheriskfreeratemeansthattheslopeoftheSMLisshallowerinpracticethanin
theory.
Overall,itseemsreasonabletoconcludethatwhiletheassumptionsoftheCAPMrepresentanidealised
ratherthanrealworldview,thereisastrongpossibility,inreality,ofalinearrelationshipexistingbetween
requiredreturnandsystematicrisk.
WACCANDCAPM
Theweightedaveragecostofcapital(WACC)canbeusedasthediscountrateininvestmentappraisal
providedthatanumberofrestrictiveassumptionsaremet.Theseassumptionsarethat:
theinvestmentprojectissmallcomparedtotheinvestingorganisation
thebusinessactivitiesoftheinvestmentprojectaresimilartothebusinessactivitiescurrentlyundertakenbythe
investingorganisation
thefinancingmixusedtoundertaketheinvestmentprojectissimilartothecurrentfinancingmix(orcapitalstructure)of
theinvestingcompany
existingfinanceprovidersoftheinvestingcompanydonotchangetheirrequiredratesofreturnasaresultofthe
investmentprojectbeingundertaken.

TheseassumptionsessentiallystatethatWACCcanbeusedasthediscountrateprovidedthatthe
investmentprojectdoesnotchangeeitherthebusinessriskorthefinancialriskoftheinvesting
organisation.
Ifthebusinessriskoftheinvestmentprojectisdifferenttothatoftheinvestingorganisation,theCAPM
canbeusedtocalculateaprojectspecificdiscountrate.Theprocedureforthiscalculationwascoveredin
thesecondarticleinthisseries(Projectspecificdiscountrates,StudentAccountant,April2008).
ThebenefitofusingaCAPMderivedprojectspecificdiscountrateisillustratedinFigure2.Usingthe
CAPMwillleadtobetterinvestmentdecisionsthanusingtheWACCinthetwoshadedareas,whichcan
berepresentedbyprojectsAandB.
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ProjectAwouldberejectedifWACCwasusedasthediscountrate,becausetheinternalrateofreturn
(IRR)oftheprojectislessthanthatoftheWACC.Thisinvestmentdecisionisincorrect,however,since
projectAwouldbeacceptedifaCAPMderivedprojectspecificdiscountratewereusedbecausethe
projectIRRliesabovetheSML.Theprojectoffersareturngreaterthanthatneededtocompensateforits
levelofsystematicrisk,andacceptingitwillincreasethewealthofshareholders.
ProjectBwouldbeacceptedifWACCwasusedasthediscountratebecauseitsIRRisgreaterthanthe
WACC.
Thisinvestmentdecisionisalsoincorrect,however,sinceprojectBwouldberejectedifusingaCAPM
derivedprojectspecificdiscountrate,becausetheprojectIRRoffersinsufficientcompensationforitslevel
ofsystematicrisk(WatsonandHead,pp2523).

ADVANTAGESOFTHECAPM
TheCAPMhasseveraladvantagesoverothermethodsofcalculatingrequiredreturn,explainingwhyit
hasremainedpopularformorethan40years:
Itconsidersonlysystematicrisk,reflectingarealityinwhichmostinvestorshavediversifiedportfoliosfromwhich
unsystematicriskhasbeenessentiallyeliminated.
Itgeneratesatheoreticallyderivedrelationshipbetweenrequiredreturnandsystematicriskwhichhasbeensubjectto
frequentempiricalresearchandtesting.
Itisgenerallyseenasamuchbettermethodofcalculatingthecostofequitythanthedividendgrowthmodel(DGM)in
thatitexplicitlytakesintoaccountacompanyslevelofsystematicriskrelativetothestockmarketasawhole.
ItisclearlysuperiortotheWACCinprovidingdiscountratesforuseininvestmentappraisal.

DISADVANTAGESOFTHECAPM
TheCAPMsuffersfromanumberofdisadvantagesandlimitationsthatshouldbenotedinabalanced
discussionofthisimportanttheoreticalmodel.
AssigningvaluestoCAPMvariables
InordertousetheCAPM,valuesneedtobeassignedtotheriskfreerateofreturn,thereturnonthe
market,ortheequityriskpremium(ERP),andtheequitybeta.
TheyieldonshorttermGovernmentdebt,whichisusedasasubstitutefortheriskfreerateofreturn,is
notfixedbutchangesonadailybasisaccordingtoeconomiccircumstances.Ashorttermaveragevalue
canbeusedinordertosmoothoutthisvolatility.
FindingavaluefortheERPismoredifficult.Thereturnonastockmarketisthesumoftheaverage
capitalgainandtheaveragedividendyield.Intheshortterm,astockmarketcanprovideanegative
ratherthanapositivereturniftheeffectoffallingsharepricesoutweighsthedividendyield.Itistherefore
usualtousealongtermaveragevaluefortheERP,takenfromempiricalresearch,butithasbeenfound
thattheERPisnotstableovertime.IntheUK,anERPvalueofbetween2%and5%iscurrentlyseenas
reasonable.However,uncertaintyabouttheexactERPvalueintroducesuncertaintyintothecalculated
valuefortherequiredreturn.
Betavaluesarenowcalculatedandpublishedregularlyforallstockexchangelistedcompanies.The
problemhereisthatuncertaintyarisesinthevalueoftheexpectedreturnbecausethevalueofbetaisnot
constant,butchangesovertime.
UsingtheCAPMininvestmentappraisal
ProblemscanarisewhenusingtheCAPMtocalculateaprojectspecificdiscountrate.Forexample,one
commondifficultyisfindingsuitableproxybetas,sinceproxycompaniesveryrarelyundertakeonlyone
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businessactivity.Theproxybetaforaproposedinvestmentprojectmustbedisentangledfromthe
companysequitybeta.Onewaytodothisistotreattheequitybetaasanaverageofthebetasofseveral
differentareasofproxycompanyactivity,weightedbytherelativeshareoftheproxycompanymarket
valuearisingfromeachactivity.However,informationaboutrelativesharesofproxycompanymarket
valuemaybequitedifficulttoobtain.
Asimilardifficultyisthattheungearingofproxycompanybetasusescapitalstructureinformationthat
maynotbereadilyavailable.Somecompanieshavecomplexcapitalstructureswithmanydifferent
sourcesoffinance.Othercompaniesmayhavedebtthatisnottraded,orusecomplexsourcesoffinance
suchasconvertiblebonds.Thesimplifyingassumptionthatthebetaofdebtiszerowillalsoleadto
inaccuracyinthecalculatedvalueoftheprojectspecificdiscountrate.
OnedisadvantageinusingtheCAPMininvestmentappraisalisthattheassumptionofasingleperiod
timehorizonisatoddswiththemultiperiodnatureofinvestmentappraisal.WhileCAPMvariablescanbe
assumedconstantinsuccessivefutureperiods,experienceindicatesthatthisisnottrueinreality.
CONCLUSION
ResearchhasshowntheCAPMtostandupwelltocriticism,althoughattacksagainstithavebeen
increasinginrecentyears.Untilsomethingbetterpresentsitself,however,theCAPMremainsavery
usefuliteminthefinancialmanagementtoolkit.
WrittenbyamemberofthePaperF9examiningteam

Backtotop
Lastupdated:10Aug2015

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