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Capital Asset Pricing Model (CAPM) is one of the models used in calculating the cost of equity. Recent reports have indicated that this model is a major approach in the calculating the cost of equity, which is in turn used to determine the weighted average cost of capital (WACC) for valuation of equity and investment appraisal reasons. This model was developed as the first rational framework for determining how an investment's risk should affect its expected return, which is one of the fundamental questions or issues in finance. Capital Asset Pricing Model (CAPM), which was developed in early 1960s, is based on the notion that not all risks should have impact on prices of assets. The significance of this model is demonstrated in its provision of a formula that calculates the expected return on an investment (or security) depending on its level of risk. In this case, the expected return is increase in value expected from a security based on the asset's intrinsic level of risk.
Problem Arising from CAPM
Despite the significance this model plays in calculation of the cost of equity, CAPM has generated a misleading belief that an individual should expect rewards for bearing systematic...
This is primarily because the model has been misconstrued to imply that it's reasonable to expect and eventually require a competitive asset market to offer a high rate of return. The expectation of a higher rate of return in turn acts as the necessary incentive for investors to bear systematic risk (Dawson, 2014, p.569). Given this misinterpretation, the investment advisory profession no longer provides due diligence services about the fundamentals of an asset to potential investors.
The general acceptance of positive risk-return paradigm brought by Capital Asset Pricing Model is not only misleading but also represents an incomplete basic analysis of an asset market. Consequently, it is wrong to interpret that the positive, linear relation between expected beta risk and expected return in CAPM implies that investors using this model are paid for bearing systematic risk. In essence, a competitive asset market does not need to totally compensate the marginal investor for extra investments in systematic risk linked to investing in a risky asset instead of one that is risk-free. In light of these factors, the capital asset pricing model is theoretically deficient in its demand-side emphasis and risk-averse investments. While it legitimizes the belief that investors can obtain high returns for bearing systematic…
References
Dawson, P.C. (2014, November 15). The Capital Asset Pricing Model in Economic Perspective. Applied Economics, 47(6), 569-598.
Nel, W.S. (2011, July 4). The Application of the Capital Asset Pricing Model (CAPM): A South African Perspective. African Journal of Business Management, 5(13), 5336-5347.
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