The Capital Assets Pricing Model is a model used b y investors to find the relationship between their required rate of return from an investment and the systematic risk of the investment.
It is a tool used by investors and companies to accurately estimate the rate of returns of investments and projects with risks involved.
The Capital Asset Pricing Model is a unique model when it comes to appraising investments as it considers the systematic risk of an investment. Systematic risk is a risk that applies to the market as a whole and not to a specific investment.
The model also assumes the investors hold a diversified portfolio of investments, thus, eliminating any unsystematic risks involved with an investment as well. Unsystematic risk is the risk of a specific investment.
Other tools such as the Dividend Discount Model or Discounted Cash Flows model do no consider the risks involved with an investment. This makes the Capital Asset Pricing Model a superior tool to these when it comes to evaluating investments with risks involved.
Companies also prefer this model over the Weighted Average Cost of Capital because the Weighted Average Cost of Capital fails when the risk of the investment is not the same as the risk of the company.
While the Capital Asset Pricing Model has many advantages when it comes to evaluating investments with different risks, it does have some limitations or disadvantages, as below.
Limitations of the Capital Asset Pricing Model
1) The Risk-free Rate of Return:
In order to calculate the rate of return of an investment using the Capital Asset Pricing Model, it is important for investors to determine the risk-free rate of return. The risk-free rate of return is a theoretical rate of return of an investment with no risk.
Usually, the risk-free rate of return is taken as the rate of return of government treasury bills as they are deemed to have minimal risk.
However, this risk-free rate of return is just theoretical and does not practically exist. Even when considering government treasury bills, they are not completely risk-free and carry risk to some extent.
However, since the risk is minimal, therefore, they are taken as the risk-free rate of return.
Furthermore, the rate of risk-free rate of return changes often and is never constant. This makes calculating rate of return using the model even more difficult.
Investors need to average out the changes over a period of time to get an average value for the risk-free rate of return which can be difficult.
2) Calculating Beta Coefficient
Beta coefficient is the measure of the systematic risk of an investment. It allows investors to understand the relationship between the changes in the market and their effect on a company’s stock value. The beta coefficient of companies that are public-listed are calculated regularly and available to the public. However, if an investor is considering investing in a non-listed company, they have to calculate the beta coefficient themselves.
In addition, like the risk-free rate of return, the beta coefficients of an investment can also change over time. Although beta coefficient values for public-listed companies are regularly calculated and publicly available to investors, they are not constant. This creates uncertainty for investors trying to estimate the rate of returns on their investments.
Furthermore, as the beta coefficient is the measure of the systematic risk of a company for a particular market, it is difficult to calculate for companies that operate in different markets or segments. For example, Samsung operates in different markets such as smartphones, televisions, insurances and even ship building. It is difficult to calculate a beta coefficient that considers the risks of all these markets. This even makes the beta coefficient incomparable with other companies.
In situations such as the above, a proxy beta is used. However, the data to calculate proxy betas is also difficult to obtain.
3) Return on the Market
The average return on the market is the sum of all average returns from an investment. These returns can either be in the form of share price appreciation or in the form of dividends received from the investment. The Capital Asset Pricing Model considers the return on the market when calculating the rate of return of an investment.
The model always expects positive average returns on the market. However, when the average return on the market is negative, at a given time, investors have to use long term market returns to compensate for it.
In addition, the return on the market takes historical data from investments into consideration. Therefore, any current or future changes in the market returns of an investment are neglected and may result in inaccuracies.
Most of the other limitations of the Capital Asset Pricing Model stem from the assumptions the model makes when calculating the rate of return of an investment. These limitations due to the assumptions are:
5) Borrowing Assumptions
The Capital Asset Pricing Model assumes investors can borrow and lend money without any limitations at a risk-free rate. This is an impractical assumption as practically investors cannot do so. The risk-free rate of return, as mentioned, is taken as the rate of return from government treasury bills. Investors cannot borrow or lend money at the government rates in the market.
6) Single Period Assumption
The Capital Asset Pricing Model assumes that investors are only interested in knowing the rate of return for a single period. This assumption is unrealistic in the real world as usually investors look to invest in stocks and other instruments for more than a single period.
7) Unsystematic Risk Assumption
As mentioned, the Capital Asset Pricing Model assumes that the investors hold a diversified portfolio of investments. This may not be true for small investors that have only invested in a single market or investors with an undiversified portfolio.
8) Perfect Market Assumption
The Capital Asset Pricing Model assumes a perfect market when calculating the rate of return of an investment. A perfect market is a market when all information regarding investments is readily available to the investors. A perfect market is only a theoretical market and does not exist in the real world.
9) Transaction Fees
The Capital Asset Pricing Model also assumes there are no transaction fees involved when investing. This is a part of the perfect market assumption that the model makes. In a perfect market these transaction fee would not exist. Practically, there are many transaction fees like legal fee, taxes and bid-ask spread involved.
The Capital Asset Pricing Model can be used to determine the rate of return of an investment. While it is widely used and has many advantages, it does come with a set of limitations or disadvantages. These limitations may arise when calculating the rate of return using the model using different variables such as risk-free rate of return, beta coefficient or the average return on the market. Additionally, these limitations may also arise from the assumptions this model makes.