Question

In applying the CAPM to estimate the cost of equity capital, which of the following elements is not subject to dispute?

a) the market risk premium

b)the stock's beta coefficient

c) the risk-free rate

d) all of the above are subject to dispute

The answer is D, but i'm searching for a detailed explaination on why its correct.

Answer 1

WE know that

The CAPM formula requires only three pieces of information: the rate of return for the general market, the beta value of the stock in question and the risk-free rate.

Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)

Market risk premium may be calculated on the basis of

• equired market risk premium – the minimum amount investors should accept. If an investment’s rate of return is lower than that of the required rate of return, then the investor will not invest. It is also called hurdle rate of return.
• Historical market risk premium – a measurement of the return’s past investment performances taken from an investment instrument that is used to determine the premium. The historical premium will produce the same result for all investors as the value’s calculation is based on past performances.
• Expected market risk premium – based on the investor’s return expectation.

Since all the methods will give different values, there is no way to reach a set value

Also, The return on the market can be described as the sum of the capital gains and dividends for the market. A problem arises when at any given time, the market return can be negative. As a result, a long-term market return is utilized to smooth the return. Another issue is that these returns are backward-looking and may not be representative of future market returns.

Businesses that use CAPM to assess an investment need to find a beta reflective to the project or investment; often a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the reliability of the outcome.
Also, beta is based on historical data.

The risk free rate of return is always disputable as it may be able to diversify the unsystematic risk of the portfolio, a systematic risk is always there, i.e. if the goverment collapses and millitary takes over, one might not get their money back even from govt securities. Further, The commonly accepted rate used as the R_f is the yield on short-term government securities. The issue with using this input is that the yield changes daily, creating volatility.