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Capital Asset Pricing Model Assistance

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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 its components.
Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.
Identify the benefits and drawbacks of using the CAPM.

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Explain how the CAPM assists in measuring both risk and return.

The capital asset pricing model (CAPM) is used to calculate investment risk and what return on investment one should expect by providing a usable measure of risk that helps investors determine what return they deserve for putting their money at risk. The model states that investments contain two types of risk:

1. Systematic risk - These are the market risks that cannot be removed through diversification, such as interest rates, recessions and wars.

2. Unsystematic risk - These risks are specific to individual stocks and can be removed through diversification by increasing the number of stocks in one's portfolio.

CAPM is used as a way to measure and deal with systematic risk in order to maximize return. According to the model, beta is the only relevant measure of a stock's risk, or volatility, by determining how the price of a specific stock increases or decreases as compared with how much the stock market increases or decreases. When beta is compared with the equity risk premium, it shows the amount of compensation equity required by investors for taking on additional risk. By knowing the individual components of CAPM, it is possible to determine whether or not the current price of a stock is consistent with its likely return. The model basically states that the only reason an investor should earn more on average by investing in one stock rather than another is that one stock is riskier (Mullins, 1982).

Explain how the CAPM assists in ...

Solution Summary

Capital asset pricing model assistance is examined.The benefits and drawbacks of using the CAPM is determined.

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Dividend Growth Model or the Capital Asset Pricing Model

Do you feel that the Dividend Growth Model or the Capital Asset pricing Model is more accurate in determine the cost of a firm's common equity? Defend your answer.

Mini Case: After collaborating with people form your finance department, you have completed the analysis of purchasing five new delivery trucks. Using your firm's weighted average cost of capital, it appears that there is not a fleet of trucks that can be purchased that has a positive NPV. Your boss tells you that you should be using the cost of a truck loan (6%) rather than the weighted average cost of capital (14%) to analyze this purchase. By using 6%, even the purchase of Volvo trucks has a positive NPV. Using WACC you can not even justify the purchase of Yugo trucks. What should you tell your boss? How would your response change, if at all, if you were working for a not-for-profit organization? ( this can be another paragraph or 2 thanks)

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