Capital Asset Pricing Model (CAPM)

Posted: July 9th, 2021

Week 4 Discussion

CAPM is a model that is used to show the interrelation that exists between an investor’s expected returns and the risk involved in a project or business (Elbannan, 2015). It is used in the pricing of high-risk securities or assets. The model has various strengths and benefits to the organization. First, the model is easy to use. Second, CAPM only looks at the systematic risk, which is effective since most investors have diversified portfolios that do not have unsystematic risk. Compared to other methods or models of calculating the expected returns, CAPM is superior in the provision of discount rates for purposes of investment appraisal (Elbannan, 2015). CAPM is a highly effective model of calculating equity cost as it considers the organization’s risk in relation to the stock market. Lastly, CAPM can be used together with the small or securities market line. The securities market line (SML) is a line that plots the market risk versus the market return at a particular time (Jylhä, 2018). It reflects all the marketable securities that are risky. The SML shows the results obtained from the use of the CAPM graphically. The slope of the SML determines the market risk premium.

Equity Financing vs Debt Financing

Equity financing is better than debt financing for the company. This is because equity financing is more committed to the business and all the intended projects. This is because investors can only realize gains on investment when the company is performing well. Through equity financing, the company will avoid keeping up with the costs of servicing bank loans and other debts, which will allow the company to use all its capital for business operations and realizing company growth (Huang, Ritter, & Zhang, 2016).

References

Elbannan, M. A. (2015). The capital asset pricing model: an overview of the theory. International Journal of Economics and Finance, 7(1), 216-228.

Huang, R., Ritter, J. R., & Zhang, D. (2016). Private equity firms’ reputational concerns and the costs of debt financing. Journal of Financial and Quantitative Analysis, 51(1), 29-54.

Jylhä, P. (2018). Margin requirements and the security market line. The Journal of Finance, 73(3), 1281-1321.