The presentation on Capital Asset Pricing Model.

2.  A widely – used valuation model , known as the Capital Asset Pricing Model ,
seeks to value financial assets by linking an asset’s return and its risk .
 Prepared with two inputs : The market’s overall expected return and an asset’s
risk compared to the overall market
 The CAPM predicts the asset’s expected return and thus a discount rate to
determine price .
 The Capital Asset Pricing Model (CAPM) estimates the expected return on an
investment given its systematic risk.
 The cost of equity – i.e. the required rate of return for equity holders – is
calculated using the CAPM.

3.  CAPM is an framework for determining the equilibrium expected return for risky
assets .
 Relationship between expected return and systematic risk of individual assets or
securities or portfolios .
 The general idea behind CAPM is that investors need to be compensated in two
ways : time value of money and risk
 William F Sharpe developed the CAPM .
 He emphasized that risk factor in portfolio theory is a combination of two risk ,
systematic and unsystematic risk .

4. 1. Can lend and borrow unlimited amounts under the risk free rate of interest.
2. Assume all information is available at the same time to all investors
3. The market is perfect :
 there are no taxes
 there are no transaction costs
 securities are completely divisible
 The market is competitive.

5.  To work with the CAPM have to understand three things
:
1. The kinds of risk implicit in a financial asset
(namely diversifiable and non - diversifiable risk )
2. An asset's risk compared to the overall market risk
3. It’s called beta coefficient (ß)
4. The linear formula ( or security market line ) that
relates return and ß .

6.  Investors will always combine a risk free asset with a market
portfolio of risky assets .
 Investors will invest in risky assets in proportion to their market
value.
 Investors can expect returns from their investment according to the
risk.
 This implies a liner relationship between the asset’s expected return
and its beta .
 Investors will be compensated only for that risk which they cannot
diversify .
 This is the market related ( systematic ) risk

7.  CAPM Formula Assumptions
 The cost of equity is most commonly estimated using the CAPM, which links the
expected return on a security to its sensitivity to the overall market.
 The formula is comprised of three components:
1. Risk-Free Rate (rf): The return received from risk-free investments — most often
proxied by the 10-year treasury yield
2. Beta (β): The measurement of the volatility (i.e. systematic risk) of a security
compared to the broader market (S&P 500)
3. Equity Risk Premium (rm – rf): The incremental return received from investing in
the market (S&P500) above the risk-free rate (rf, as described above)

8.  The CAPM begins with the insight that financial assets contain two kinds of risk .
1. There is risk that is diversifiable it can be eliminated by combining the
asset with other assets in a diversified portfolio.
2. And there is non diversifiable risk - risk that reflects the future is
unknowable and cannot be eliminated by diversification.
 Beta(ß)
 Also known as “ beta coefficient . “
 A measure of the volatility , or systematic risk , of a security or a portfolio
in comparison to the market as a whole.
 Beta is used in the capital asset pricing model ( CAPM ) , a model that
calculates the expected return of an asset based on its beta and expected
market returns .

9.  The expected return, or cost of equity, is equal to the risk-free rate plus
the product of beta and the equity risk premium
 The formula for calculating the expected return of an asset given its risk
is as follows:
 Expected Return (Ke) = rf + β (rm – rf)
 Where
 Ke → Expected Return on Investment
 rf → Risk-Free Rate
 β → Beta
 (rm – rf) → Equity Risk Premium (ERP)

10.  The graph below of expected returns
(y-axis) with the beta (x-axis)
connects the relationships between
the three variables.
 Note that the green dotted line
represents the risk-free rate, while
the orange dotted line depicts the
market return (i.e. beta of 1.0).
 Thus, the difference between the
return from the risk-free rate and
market return is the equity risk
premium.

11.  Suppose we have three companies that each share the following assumption:
 Risk-Free Rate = 2.5%
 Expected Market Return = 8.0%
 Since we’re given the expected return on the market and risk-free rate, we can
calculate the equity risk premium for each company using the formula below:
 Equity-Risk Premium (ERP) = 8.0% – 2.5% = 5.5%
 The difference in expected returns among the three companies will be attributable
to the beta (i.e. systematic risk).
 Company A = 0.5 Beta
 Company B = 1.0 Beta
 Company C = 1.5 Beta

12.  To calculate the cost of equity (Ke), we’ll take the risk-free rate and
add it to the product of beta and the equity risk premium, with the
ERP calculated as the expected market return minus the risk-free
rate.
 For example, Company A’s cost of equity can be calculated as:
 Cost of Equity (Ke) = 2.5% + (0.5 × 5.5%) = 5.3%
 Under the provided assumptions, the expected equity returns for the
three companies come out to 5.3%, 8.0%, and 10.8%, respectively.

13.  Diversifiable risk sometimes called unsystematic risk.
 That part of an asset's risk arising from random causes that can be eliminated
through diversification.
 For example , the risk of a company losing a key account can be diversified away
by investing in the competitor that look the account .
• Non - diversifiable risk sometimes called systematic risk.
• The risk attributable to market factors that affect all firms and that cannot be eliminated
through diversification.
• For example , if there is inflation , all companies experience an increase in prices of inputs , and
generally their profitability will suffer if they cannot fully pass the price increase on to their
customers .

14.  There are numerous advantages to the application of CAPM
 Ease-of-use : CAPM is a simplistic calculation that can be easily tested to derive
a range of possible outcomes to provide confidence around the required rates of
return.
 Diversified Portfolio : The assumption that investors hold a diversified portfolio ,
similar to the market portfolio , eliminates the unsystematic risk .
 Systematic risk ( B ) : CAPM takes into account systematic risk , which is left out
of other return models.
 Business and Financial Risk Variability : When businesses investigate
opportunities , if the business mix and financing differ from the current business ,
then other required return calculations .

15.  Risk - free Rate ( Rf ):
 The commonly accepted rate used as the R , is the yield on
short - term government securities .
 Return on the Market ( Rm ):
 The return on the market can be described as the sum of the
capital gains and dividends for the market.
 A problem arises when at any given time , the market return
can be negative.
 As a result , a long - term market return is utilized to smooth
the return .

16.  Ability to Borrow at a Risk–free Rate:
 The minimum required return line might actually be less steep than the model
calculates.
 Determination of Project Proxy Beta:
 Businesses that use CAPM to assess an investment need to find a beta reflective
to the project or investment . Often a proxy beta is necessary.
 However , accurately determining one to properly assess the project is difficult
and can affect the reliability of the outcome .

17. CAPM has the following limitations:
1. It is based on unrealistic assumptions.
2. It is difficult to test the strength of
CAPM.
3. Betas do not remain stable over time .