The Capital Asset Pricing Model (CAPM) is a tool that investors can use to calculate the rate of return of different investments. This model describes the linear relationship between the systematic risk of an investment and the required rate of return of the investment.
It can be used with different investment appraisal techniques when evaluating investments.
The Capital Asset Pricing Model is widely used by investors for investment appraisal purposes. This is because this model is easy to understand and use. The data required to calculate the rate of return using this tool can easily be obtained from the market.
The results obtained from the tool are also accurate and reliable. These are the factors that make this model the first choice for many investors, analysts, and experts.
The Capital Asset Pricing Model allows investors to calculate the risk premium of a stock which allows investors to determine the value of return they get for the risk they are taking with the investment.
Furthermore, it allows investors to consider the systematic risk involved in investment using the beta coefficient.
This makes it a superior tool over other investment appraisal tools such as the Weighted Average Cost of Capital or the Dividend Discount Model as they do not consider the risks involved in an investment.
The Capital Asset Pricing Model makes some assumptions when calculating the rate of return of an investment.
It assumes that the investor holds a diversified portfolio of stocks, therefore, eliminating any unsystematic risk involved. This only leaves the systematic risks of an investment for investors to deal with.
Another assumption that this model makes is the assumption of a perfect market where all information is readily available to the investors. Based on the perfect market assumption, the Capital Asset Pricing Model also makes many other assumptions.
These assumptions include the availability of borrowing and lending to investors at risk-free rate without limitations, single period requirement assumption, no transaction fees existing for the investment, etc.
Calculating the Expected Rate of Return Using CAPM
The expected rate of return of an investment can be calculated using CAPM by calculating the sum of the risk-free rate of return and the risk premium of an investment. The above statement can be written in the form of a formula as:
Expected rate of return = Risk-free rate of return + Risk premium
A risk-free rate of return is the rate of return for a risk-free investment. This is a theoretical rate of return and is usually taken as the rate of return of short-term government treasury bills. While government treasury bills are not truly risk-free, the risks involved are minimal.
Risk premium is the excess amount of return over the risk-free rate of return. This represents the return on risk involved for an investment. The risk premium can be calculated using the formula:
Risk premium = Beta coefficient x (Expected average return on the market – Risk-free rate of return)
The beta coefficient is a measure of the systematic risk of an investment. The beta coefficient is lower than 1 for investments with a lower risk, above 1 for investments with higher risk, and equal to 1 for investments with the same risk as to the market.
Thus, substituting the value of the risk premium in the formula of the Capital Asset Pricing Model, the formula becomes:
Expected rate of return = Risk-free rate of return + [Beta coefficient x (Expected average return on the market – Risk-free rate of return)]
From the above formula, the rate of return of an investment can be calculated. This rate of return can then be used for investment appraisal with different techniques such as NPV, IRR, Discounted Payback Period, etc. to evaluate the investment being considered.
For example, ABC Co. operates in a market where the average return on the market is 11% while the rate of return on government treasury bills is 6%. The beta coefficient of ABC Co. is 1.3. Using the data provided, the rate of return of investment in ABC Co. will be 12.5% (6% + 1.3 x (11% – 6%)).
This rate can be used by investors with different investment appraisal tools to discount any future cash flows from investing in ABC Co. Additionally, ABC Co. can use this rate of return as their cost of capital when appraising investments.
Investment Appraisal Methods
Once a rate of return is established from the CAPM, this rate of return can be used with different techniques for investment appraisal. These techniques are:
1) Net Present Value
The Net Present Value (NPV) is the sum of all the future cash flows from an investment discounted at a rate of return less any investment costs. This value represents any excess funds that the investment will generate for the investor.
Investors can make decision regarding an investment by considering the Net Present Value of that investment.
The NPV estimates the impact of an investment on the investor’s wealth. The rate used to calculate this NPV can be obtained using CAPM.
Once the NPV of an investment is calculated, the investor can make a decision whether to consider the investment or not. If the NPV of an investment is positive (greater than 0), then it means that the investment will generate cash for the investor and, therefore, is financially feasible.
If the NPV of an investment is negative (less than 0), then the investment will not generate any funds and also not compensate for any costs of investment, thus, the investment is not financially feasible. If the NPV of an investment is 0, then the investment will break even.
2) Internal Rate of Return
Internal Rate of Return (IRR) is the discount rate at which the NPV of an investment is equal to 0.
This rate is compared to the rate of return obtained from the CAPM by investors to make a decision regarding the investment.
If the IRR of an investment is greater than the rate of return obtained from CAPM, then the investment is accepted and is considered financially feasible.
3) Discounted Payback Period
The rate of return obtained from the CAPM can also be used to calculate the Discounted Payback Period of an investment. Discounted Payback Period of an investment represents the expected payback period of the investment.
Unlike the regular payback period, Discounted Payback Period discounts any future expected cash flows. If the payback period obtained from this technique is within the payback period expectation of the investor, the investment is considered financially feasible and accepted.
The Capital Asset Pricing Model is used to measure the rate of return of an investment. This rate of return is calculated by considering the risk-free rate of return and the risk premium of an investment.
Once a rate of return is obtained from the model, it can be used with different investment appraisal techniques to determine the feasibility of investment.
These might include techniques such as calculating the Net Present Value, the Internal Rate of Return, or the Discounted Payback Period of the investment.