Question

Explain how the CAPM assists in measuring both risk and return. Explain how the CAPM assists in calculating the weighted average costs of capital WACC and it's components. why do some managers have difficulty applying the capital asset pricing model in financial decision making.

Answer 1

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Explain how the CAPM assists in measuring both risk and return. Explain how the CAPM assists in calculating the weighted average costs of capital WACC and it's components. why do some managers have difficulty applying the capital asset pricing model in financial decision making.

EXPLANATION:

In finance, capital asset pricing model (CAPM) is very significant and from this method required rate of return is calculated. According to CAPM the expected rate of return is calculated as by multiplying the beta of security by risk premium and then adding the risk free return into it. Risk premium is nothing but the difference between the market rate and the risk free return.

Risk and Return analysis is modern theory to make a investment with carefully selection of securities to maximize the expected return on the portfolio for a calculated risk. Wide range of selection of securities provides diversification so the effect of change in market factors can be reduced to a fixed level. If an investor wants expected return from the investment made by him then the portfolio management is necessary and the risk level can be reduced by selection of securities carefully and this theory reduces the level of unsystematic risk only because the systematic cannot be reduced.

            CAPM is calculate expected return on the assets it requires risk free rate, market rate of return, and beta to calculate expected rate of return. Arbitrage Pricing Model is often used as alternative to the CAPM, this model is known as two factor model. This model suggest that how the change in the macro factors affect the value of investments.

CAPM is multi factor model so it considers more than one factor while calculating the expected rate of return from the investment hence it is best from the APM model because the expected return on investment is affect with change in every macro factors. When the expected return is calculated from the APM model then following steps is followed:

            At first decide risk free rate of return and the beta of risk free rate should be zero.

            Then calculate risk premium for each factor.

Then calculate the beta value for each factor, beta is the sensitivity of return on assets to change in the factor.

The CAPM is best for the investor to calculate the expected return because as above discussed it consider more than one factor to calculate the expected return and this consideration is also necessary because the all the factor in the economy affect the return on investment.

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