Capital Asset Pricing Model (3) Flashcards
Assumption of CAPM (risk)
Total risk can be split between systematic risk and unsystematic risk.
Assumption of CAPM (unsystematic)
Unsystematic risk can be completely diversified away
Assumption of CAPM (risk-free)
A risk-free security exists which provides a minimum level of return required by investors.
Why is investors can borrow and lend at risk-free rate unreasonable?
Risk associated with individual investors is much higher than that associated with the government
Assumption of CAPM (diversified)
All of a company’s shareholders hold well-diversified portfolios. Ideal for ignoring unsystematic risk
Assumption of CAPM (market)
A perfect capital market as for the dividend valuation model
Advantages of CAPM (WACC)
It is superior to using the existing WACC as the discount rate for a project with different business risk compared to existing operations
Advantages of CAPM (systematic)
It considers only systematic risk
Advantages of CAPM (dividend growth)
It is generally seen as a much better method of calculating the cost of equity than the dividend growth model.
Disadvantages of CAPM (single period model)
Whereas company projects are often multi-period
Disadvantages of CAPM (index)
It is a single index model
Disadvantages of CAPM (overstate)
CAPM tends to overstate the required return on very high-risk companies and understate the returns on very low-risk companies.
Disadvantages of CAPM (data)
Lack of data for the model − particularly in developing markets
