Accounting & Financial Management: Asset Pricing Essay

Part A – A Critique of the Capital Asset Pricing Model

CAPM:

Capital asset pricing model starts where Markowitz left off. The CAPM developed by William F Sharpe, Jan Mossin, and John Linter is one of the significant developments in the financial industry. The capital asset pricing model talks about the expected return from an asset and the risk associated with it. CAPM model is used to measure the expected returns of the risky securities. According to CAPM, the investor can be compensated by either the time value of money (TVM) or risk. The model is based on some assumptions. Those are:

Assumptions underlying the theory:

Relationship of CML and SML:

The capital market line reflects the relationship between the excessive return of the portfolio over the risk-free rate, and the total risk of that portfolio. According to the Markowitz portfolio theory, any portfolio below the CML must be inefficient. IN another word, investors will not invest in such kind of portfolios that are dominated by portfolio combinations on the CML. Nevertheless, in the market, some investors hold the portfolio that lies below CML. The reason for this is that the market will not compensate the investors for bearing the total risk of the portfolios. Instead, the market only compensates investors for bearing the systematic risk of portfolios, as it is believed that any specific risk can be diversified away by the investors. This results in the existence of the Security Market Line (SML), which depicts the relationship between portfolio's excessive return over the risk-free rate and the portfolio's systematic risk- represented by beta. For the market portfolio, it has an only systematic risk, so the beta of the Market Portfolio is one (Elbannan 2015 p.216).

CML measures risk by standard deviation or total risk. SML measures risk by beta to or systematic risk. A CML graph only defines efficient portfolios, but the SML graph defines both efficient and non-efficient portfolios. CML eliminates diversifiable risks for portfolios. SML includes all portfolios that lie on or below the CML, but only as a part of M, and the associated risk is the security's contribution to M's risk. Firm's specific risk is irrelevant to each, but for different reasons (AAFM 2014).

Figure 1- CML Vs. SML

(Source: Author)

Arguments in favor of and against CAPM:

Capital Asset Pricing Model or CAPM or CAPM model is such a theory, which has a lot of followers as well as a lot of critiques. There is always arguments exists over CAPM model. These arguments are discussed below:

In favor:

As CAPM model only considers the systematic risk, it reflects the reality which suggests that the investors hold diversified portfolio without unsystematic risk.

CAPM helps to create a theory based relationship between the systematic risk and required rate of return.

CAPM has been considered a much better method to calculate the cost of capital than the Dividend Growth Model.

CAPM model provides WACC the necessary discount rates which are used for the purpose of appraisal of investment.

Against:

The rate used as the risk-free rate of return is the short-term government securities. The rate changes on a daily basis, which leads to volatility.

The CAPM model is built on some assumptions. Some of them are unrealistic which creates a false picture of the share market. Thus, it is not very reliable (Dobrynskaya 2014).

Uses of CAPM model:

By using the CAPM model, one can easily derive the required rate of return. This model is also used for eliminating the unsystematic risk from the equation. In CAPM model, the investors hold a diversified portfolio, which reduces the unnecessary risk.

CAPM model is used to calculate the systematic risk of the market. On another model, the systematic risk is not always considered. As a result, it creates a bad effect on the return (Mangram 2013 p.59-70).

CAPM model help to use the Weighted Average Cost of Capital in the case of investigation of business opportunities (Mazzola and Gerace 2015).

Critique of Assumptions:

The CAPM model is not a critique-free model as most of the assumptions are unrealistic. They are discussed below:

CAPM model considers that there is no transaction cost in the while trading of securities. However, in actual the assumption is incorrect as most of the trading involves huge transaction cost.

As per CAPM model, the trading process of securities is entirely tax-free, and the return is not affected by the tax rate. But there are some transactions which are subjected to tax.

CAPM says that the expectations of all the investors are same, but originally the expectations of investors vary person to person.

According to CAPM model, the govt. Bonds are entirely risk-free. But there is some govt. Bonds which are subjected to risk (Cai, Clacher and Keasey 2013).

Alternatives to CAPM model:

One of the alternatives to CAPM model is the Multi-Beta Models. There are two models in this model i.e. the Arbitrage Pricing Model & the Multifactor Model. These models work better than CAPM model in calculating the return differences.

Another alternative process is Market Price Based Models. In this model, the standard deviation is used to calculate the return. The reason is that it is easy to calculate the standard deviation than the beta.

Accounting Information Based models are another alternative if CAPM model. In this process, the risk is calculated based on the company’s fundamentals (Carter 2016).

Overall assessment of CAPM model:

CAPM is an equilibrium model. CAPM and SML are important extensions of the original ideas of Henry Markowitz and accompanying Capital Market Line. The CAPM equation validates the conclusion that systematic risk is the only essential ingredient in determining expected returns and that non-systematic risk plays no role. The investor gets rewarded for bearing systematic risk. It is not the total variance of returns that affects expected returns, but only the part of the variance in returns that cannot be diversified away. The difference between the expected market return and the risk-free return is often called the market risk premium, and the equation of the CAPM when plotted on the risk-return graph, (now using beta as a measure of risk), is referred to as the SML (AAFM 2014). CAPM is an attractive idea because it is simple and calls for that expected returns depend on upon factors that make sense. There are two kinds of risks. The investor can measure the non-diversifiable or market risk of an asset by the extent to which the value of the asset is affected by a change in the aggregate value of all the assets in the economy (Francis and Kim 2013). This is called the asset's beta. The only important risks are the ones the investor cannot get rid of- the non-diversifiable ones. This is why the required return of asset increases in line with beta (Fernandez 2015 p.4-23).

Though the model is simple, the overall assessment of the CAPM model reveals some limitations of this model. The model makes unrealistic assumptions. The parameters of the model cannot be estimated precisely. Like the definition of the market index and the firm may have changed during the estimated period. The CAPM model does not work well. If the model is right, there should be a linear relationship between returns and beta and the only variable that should explain returns is beta. The reality is that the relationship between beta and returns is weak, and other variables (size, price/book value) seem to explain differences in returns better (Mazzola and Gerace 2015 p.43), (AAFM 2014).

(b)

Harry should not purchase the machine because NPV is negative.

Reference:

Cai, C.X., Clacher, I. and Keasey, K., 2013. Consequences of the capital asset pricing model (CAPM)—a critical and broad perspective. Abacus,49(S1), pp.51-61.

Carter, B., 2016. Capital asset pricing model (CAPM) applicability in the South African context and alternative pricing models.

Mazzola, P. and Gerace, D., 2015. A Comparison Between a Dynamic and Static Approach to Asset Management Using CAPM Models on the Australian Securities Market. Australasian Accounting Business & Finance Journal, 9(2), p.43.

Dobrynskaya, V., 2014. Downside market risk of carry trades. Review of Finance, p.rfu004.

Blitz, D., Falkenstein, E.G. and Van Vliet, P., 2013. Explanations for the Volatility Effect: An Overview Based on the CAPM Assumptions. Available at SSRN 2270973.

Fernandez, P., 2015. CAPM: an absurd model. Business Valuation Review,34(1), pp.4-23.

Elbannan, M.A., 2015. The capital asset pricing model: an overview of the theory. International Journal of Economics and Finance, 7(1), p.216.

Mazzola, P. and Gerace, D., 2015. A Comparison Between a Dynamic and Static Approach to Asset Management Using CAPM Models on the Australian Securities Market. Australasian Accounting Business & Finance Journal, 9(2), p.43.

AAFM, 2014. Investment Management & Planning, Level 1.

Arnold, T., 2014. How Net Present Value Is Implemented. In A Pragmatic Guide to Real Options (pp. 1-13). Palgrave Macmillan US.

AAFM, 2014. Application Wealth Management, Level 1.

Huang, L., Ma, C. and Nakata, H., 2015. w-MPS risk aversion and the shadow CAPM: theory and empirical evidence. The European Journal of Finance, pp.1-27.

Mangram, M.E., 2013. A simplified perspective of the Markowitz portfolio theory. Global Journal of Business Research, 7(1), pp.59-70.

Francis, J.C. and Kim, D., 2013. Modern Portfolio Theory: foundations, analysis, and new developments (Vol. 795). John Wiley & Sons.