Strategic Finance

Question: Describe about the capital asset pricing model. Answer: Introduction Capital asset pricing model (CAPM) proves to be very efficient in the analytical toolkit of financial manager despite the fact that it is based on strong assumptions. CAPM proposes a very powerful theory of asset pricing by associating portfolio investment to beta (single-risk factor). It states that the expected return on an asset which is above the risk-free rate is proportional to non-diversifiable risk (Berk et. al, 2015). Many economists have criticized the reality and simplicity of this theory but its still used by firms as an effective model for calculation of cost of capital. This paper will discuss these implications in the light of recent developments. The assumptions of this model will be discussed together with the major theories and then the discussion through critics of the assumptions. It needs to be noted that despite it s popularity and usefulness, the entire concept is based upon the assumptions. Importance and development in the current scenario CAPM is still regarded as one the best financial theories ever developed and William Sharpe was even awarded for his work in CAPM and this raises a question that why are there several critics to this theory (Da et. al, 2012). It is because of the strong assumptions on which the theory is based but it is to be noted that the proponents of this model argue that capital market functions as if these assumptions are satisfied (Berk et. al, 2015). In CAPM, everyone bears same risks in varied amounts, investors grasp diversified portfolios and they require a return for their risk (systematic) as unsystematic risk can be ignored. Depending upon the expected rate of return, investors rank their portfolio and as every investor hold the same portfolio, it is normal that they are satisfied to purchase the market portfolio. Furthermore, part of the risk on these assets can be diverted by purchasing different assets (Ferris et. al, 2010). Also, the risk of these assets is not attributed to the var iability of return but this variability will be accurate if every dime of money is invested in a single asset. It is to be noted that by diversification, the risk which is unique or isolated to individual stocks can be eliminated but not that risk which is declined by the market as a whole (Vaitilingam, 2010). In this context, the assumptions of CAPM prove useful as it support in concentrating on the relation between risks (systematic) and return but the real world clearly does not agree with this idealized world and when these assumptions do not meet the expectations of real world, the effectiveness of CAPM gets affected (Davies Crawford, 2012). Hence, it is one of the major drawbacks that are the proceedings of the CAPM get affected by the assumptions. Assumptions and the importance The first assumption assumes a financial market filled with highly-educated buyers and sellers while the second assumption explains investors that care about wealth and opt more to less. Hence, it ascertains that the major inclination is towards wealth creation and a prudent additionally, the hypothetical investors demand a premium in a higher expected return form, for the risks they undertake (Da et. al, 2012). These two assumptions are the cornerstones of modern financial theory but with the development of CAPM, more assumptions are derived. These include markets without transaction costs, restriction on short-selling and borrowing, tax-free market, investors holding diversified portfolios etc (Christensen, 2011). These assumptions are not valid in the real world, for example, even a small business acquisition involves transaction costs, income from capital gains are taxed in different ways thus nullifying the assumption of tax-free market. Furthermore, Sharpe states that every investor has same belief about the return, risk and strategies of investment but in reality, investors have varied opinions on these. Despite all these, CAPM continues to roar as one of the best methods for calculating required return. The justification here is that although the assumptions are unrealistic, reality simplification is sometimes required to develop efficient models (Damodaran, 2010). These underlying assumptions alone cannot be considered for the true test of CAPM and instead the usefulness and validity must also be considered. Through the tolerance of these assumptions, an idealized but concrete model can be derived that can measure risk to return. Critics After the creation of CAPM, various researchers criticized the model. This was due to the fact that various loopholes in the model made the theory problematic but the advantages cannot be altogether neglected. CAPM assumes that risk can be measured by the standard deviation of systematic risk of an asset relative to the market standard deviation as a whole but in 1973, Fama and McBeth stated that standard deviation and Beta is irrelevant for determining the return as these cannot measure risk. Then in 1977, Richard Poll argued that CAPM and testing assets mean variance efficiency is totally same but if the market is unobservable, then the mean variance efficiency of market cannot be tested. In 1981, Rolf Banz stated that CAPM leads to misspecification as smaller firms have high risk adjusted returns than large firms. After the publication of this article, Berk, a critique of size-related anomalies, emphasized that risky firms have high returns and low market values. Further in 1992, Fama and French expressed that CAPM was useless for what it was developed (McLaney, 2003). They have written several papers in order to find an alternate for CAPM and according to their paper in 2004, they stated that the major problem with CAPM was that it constituted theory of market portfolio mainly and was based on many assumptions but this fact must not compulsorily take too much from the application of this model. In relation to this, Fama and French designed a three-factor model as an alternative to CAPM (Graham Smart, 2012). Three variables were used in this model that argued that beta was must not solely be considered for determining expected return but book-to-market ratio and market capitalization was also important. They stated that by adding these variables to the original calculation of CAPM justified around 90% of the diversified return of portfolio in comparison to the 70% of returns by CAPM (Choi Meek, 2011). Their arguments stirred the debate as they were very st rong but sooner in 1995, Kothari argued that the evidence of Fama and French were based on data that was affected by survivorship bias on the COMPUSTAT. In 1997, Daniel and Titman concluded that no higher returns were found under the three-factor model. All these developments in the area of CAPM clearly portray that however ineffective CAPM appears to be, it will still be the most popular way for ascertaining returns. In 2001, Harvey and Graham depicted through their paper that CAPM is widely used despite its assumptions and critiques. According to their research, CAPM was used on a scale of around 73.5% while a study by Bruner concluded it to be 84.5%. The Harvard Business Review prescribes that the reason behind so many critics for CAPM was that it was a relatively new model at that time but the concerns raised by it is that, firstly the value of beta are subject to alterations over time according to the change in the capital structure of company even though it is ascertained from historical or past data. Secondly, too much estimates of market return (expected) are subject to flaws. Finally, HBR drags the theoretical and practical problems by applying the CAPM model consecutively and recommends that CAPM model must be used in synchronization with other models in order to ascertain the cost of equity like Dividend Growth Model, Weighted Average Cost of Capital etc (Arnold, 2010). The developments and amendments ensured that CAPM can be used widely and that the procedure leads to a desirable result. Conclusion Hence, CAPM is still an efficient model for estimating return and cost of equity despite its assumptions and critiques. The faults lie in its applicability as well as its theoretical structure. The market portfolio theory of Markowitz model creates a downfall for CAPM and attracts many critiques (Williams, 2012). Other alternative models like Fama and Frenchs three-factor model, Dividend Growth Model, WACC etc are also used. Fischer Black models adaptation to CAPM, also called Black CAPM is viewed more realistic by professionals as the calculation does not accommodate riskless assets (Arnold, 2010). Going by the discussion it can be commented that CAPM is placed in a better fashion and provides a better aspect because the variables in CAPM is ascertained by the share price per data and beta is evaluated by utilizing the statistical method. But on a whole, this does not conclude that CAPM is not an efficient model, it is very unique in its way that considers the markets systematic ris k as a whole (Brealey et. al, 2011). 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