The Capital Assets Pricing Model is a finance tool that can be used to derive the cost of capital of a company. It is a tool widely used by companies to find their cost of capital for their equity and debt instruments. Investors also use this tool to find the expected rate of return of an investment.
Capital Assets Pricing Model describes the linear relationship between the required rate of return on investment, whether that is for a company or for an individual investor, and the systematic risk involved with the investment.
Systematic risk, also known as market risk, is the risk that applies to the market as a whole and not the specific project or investment being appraised.
7 Advantages of the Capital Asset Pricing Model
Using the Capital Asset Pricing Model over other tools such as the Dividend Discount Model or the Discounted Cash Flows model has its own advantages. These are:
1) The Risk Premium
One of the advantages of the Capital Asset Pricing Model is that it allows investors to take the risk premium of an investment into consideration and use it for further decision-making.
To understand further, it is important to know how the required rate of return on investment is calculated using the Capital Asset Pricing Model. The formula to calculate the required rate of return under this model is as follows:
Required rate of return = Risk-free rate of return + Risk premium
Risk premium is the expected return on an investment in excess of the risk-free rate of return. Risk premium takes into consideration the systematic risk of an investment.
The risk premium of investment allows investors or companies to determine the value of return for the risk they are taking. The risk premium will be high for startup companies and relatively lower for established companies.
For example, if an investor invests in the stocks of an established company such as Microsoft or Apple, the expected rate of return on the investment will rarely deviate from estimates made beforehand. This is because there is relatively lower risk involved with these companies as compared to startups.
2) The Beta
The Capital Asset Pricing Model takes into consideration the systematic risk involved in an investment.
The model takes the risks associated with an investment in the form of an amount known as the Beta coefficient. Other models such as the Dividend Discount Model (DDM) do not consider the risks involved with an investment.
This makes the Capital Asset Pricing Model the best tool to use for riskier investments.
Beta coefficient is the measure of the systematic risk or the volatility of an investment. The beta coefficient of an investment is usually either above 1 or below it.
If the beta coefficient of an investment equals 1, it means that the systematic risk of an investment is the same as the market. Any changes in the value of the investment are directly related to the changes in the market.
When the beta coefficient of an investment is above one, it means that systematic risk of the investment is more than the average systematic risk of the market.
Investments with a beta coefficient above 1 come with a high amount of risk but also come with high rewards. Inversely, when the beta coefficient of the investment is lower than 1, it means the systematic risks of the investment is lower than the market. These investments come with lower risks but also with lower returns.
Companies can also use the beta coefficient as a self-analysis tool to compare their systematic risk with the market. Companies can use this as an advantage to attract potential investors.
Furthermore, companies can use the beta coefficient to only invest in projects that will allow them to keep their beta coefficient at a controlled level.
3) Superior to Weighted Average Cost of Capital
For companies, the Capital Asset Pricing Model is a superior tool when it comes to appraising investments with different systematic risks than that of the companies. This makes it a superior tool over the Weighted Average Cost of Capital for investment appraisal.
This is because the Weighted Average Cost of Capital assumes that the systematic risk of the company is the same as the risk of the investment.
It fails when the risk of investment appraised is different than the systematic risk of the company.
Therefore, in these situations, the Capital Asset Pricing Model gives better results and allows companies to make better decisions with their investments.
4) Widely Used
The Capital Asset Pricing Model is also widely used by companies and investors when valuing investments. It is widely used due to its simplicity of usage and understandability.
Furthermore, analysts and experts use the Capital Asset Pricing Model to give their opinions on different investments due to its accuracy for risky investments.
Therefore, investors with knowledge of the model can easily obtain expert opinion on any stock of their liking.
5) Simple to Use
The Capital Asset Pricing Model is easier to use as compared to other models that calculate the rate of return of an investment.
It doesn’t require investors to understand complicated concepts such as the time value of money concept that is used in other models such as the Discounted Cash Flows model.
Furthermore, the Capital Asset Pricing Model can be used to evaluate many different scenarios or probabilities with the rate of returns to allow investors to make better decisions.
Although the Capital Asset Pricing Model makes some assumptions when calculating the rate of return of an investment, it produces an accurate result.
With investments where the risks involved are high, this model gives more accurate and reliable results than other models such as the Dividend Discount Model or the Discounted Cash Flows model.
The Capital Asset Pricing Model is many experts’ and analysts’ tool of choice for calculating the rate of return on risky investments.
7) Eliminates Unsystematic Risk
The Capital Asset Pricing Model assumes that investors hold a diversified portfolio of investments. Therefore, any unsystematic risk, the risk that is specific to an investment or industry, is eliminated.
Furthermore, it only leaves investors to deal with only systematic risks, risks that are not specific to an investment or industry, and allows for better decision-making.
The Capital Asset Pricing Model is the tool of choice for many investors, experts, and analysts for investment appraisal.
This is because it allows investors to take into consideration the risk premium and systematic risks of investments while eliminating unsystematic risk.
This makes the model a superior tool over other models when appraising risky investments. This model is also widely used due to its simplicity of usage and accuracy.