Capital Asset Pricing Model Homework
Q.1 (1.5 pages)Our discussion topic concerns the calculation of stock values using the capital asset pricing model (CAPM). Explain the CAPM model. The textbook provides a list of betas for a selection of stocks. Choose two firms from that list and discuss whether the betas are what you would expect. Be sure to explain why or why not. Calculate the returns based on the CAPM model. Be sure to state your assumptions.
Q.2 Write a reply for this discussion (for Mari) 200 words is fine for this reply
Explain the CAPM model.
CAPM stands for Capital Asset Pricing Model.
It helps us to compute the cost of the asset (particularly equity) by assigning value to the risk component in it. Capital Asset Pricing Model Homework Help
An investor typically invests in an equity to get a return which is more than the time value of money. Hence to arrive at the cost which factors both time value of money and compensation for the risk factor, CAPM is used.
Formula for CAPM
Expected Return of Investment = Risk free rate of Return + Beta * (Market Rate of Return – Risk Free Rate)
Here risk-free rate of return compensates the investor for the time value of money.
Beta compensates the investor for the risk. Hence beta is applied on the return which is above risk-free rate of return. Higher the risk investment carries, higher is the beta and consequently higher return on investment. Capital Asset Pricing Model Homework Help
Advantages of CAPM
- Simple to calculate the cost of investment
- Widely used for financial calculations and calculating Weighted Average cost of capital
Disadvantages of CAPM
- Beta never reflects the true risk in the stock and hence this may lead to inaccuracies
- It assumes a constant risk-free rate for calculations, which is never a reality.
Understanding the Capital Asset Pricing Model (CAPM)
The formula for calculating the expected return of an asset given its risk is as follows:
ERi = Rf + βi (ERm − Rf) where: ERi = expected return of investment Rf = risk-free rate βi = beta of the investment (ERm − Rf) = market risk premium ERi = Rf + βi (ERm − Rf) where: ERi = expected return of investment Rf = risk-free rate βi = beta of the investment (ERm − Rf) = market risk premium
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