What is capital asset pricing model (CAPM) in financial management?

William Sharpe, a financial economist developed Capital asset pricing, model in 1970. According to his book, “portfolio theory and capital markets”, he defined risk as systematic risk and unsystematic risk.

Systematic risk is related to interest rates, recessions etc., where perils of investing can’t be diversified. Whereas, unsystematic risk is related to stocks.

Capital Asset pricing model states relationship between systematic risks and expected returns. It based on mean variation concept. Formula is as follows −

$$R_{a}=R_{rf}+\beta_{a}\ast(R_{m}-R_{rf})$$

$R_{a}= expected\:return\:on\:a\:security,R_{rf}= risk\:free\:rate,R_{m}=expected\:return\:of\:the\:market$

$$\beta_{a}=the\:beta\:of\:the\:security,(R_{m}-R_{rf})=equity\:market\:premium$$

Assumptions are mentioned below −

• Preference of investors for risk return.
• Investors’ expectations of risk and return.
• Depending on their assessments of risk and return, they make investment decisions on rational basis.
• Investors have access to all the information.
• Investors should have same time horizons.

Advantages of capital asset pricing model are as follows −

• Ease of use.
• Diversified portfolio.
• Systematic risk.
• Business and financial risk variability.

Disadvantages are given below −

• Risk – free rate $(R_{f})$
• Return on market $(R_{m})$
• Ability to borrow at risk
• Determination of project proxy beta.

Uses of CAPM are as follows −

• Security comparison − A firm will compare all the possibilities and calculate all possibilities of risk and return and invested wisely.

• Portfolio and asset pricing − Models like CAPM, MPT helps in choosing appropriate investments for portfolio.

• Intrinsic value − Investors takes help from book value and market stick value to estimate. If trading value is lower than intrinsic value, then it’s a good deal.

• NPV − Since discount rate is same rate in CAPM, so it will have high in quality to NPV.