Applying the Applying the Capital Asset Pricing Model (CAPM)Analyze the Capital Asset Pricing Model (CAPM). Using the course text and an article from ProQuest as references, address the following:Explain how the CAPM assists in measuring both risk and return.Explain how the CAPM assists in calculating the weighted average costs of capital (WACC) and its components.Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.Identify the benefits and drawbacks of using the CAPM.Develop a 200 – 300 word answer supporting your position.Guided Response: Review several of your peers’ postings and critique their analysis. Respond to at least two of your classmates by comparing the similarities and differences of your analysis. Why do you think the responses were either similar or different? Asset Pricing Model (CAPM).Analyze the Capital Asset Pricing Model (CAPM). Using the course text and an article from ProQuest as references, address the following:Explain how the CAPM assists in measuring both risk and return.Explain how the CAPM assists in calculating the weighted average costs of capital (WACC) and its components.Illustrate why some managers have difficulty applying the Capital Asset Pricing Model (CAPM) in financial decision making.Identify the benefits and drawbacks of using the CAPM.Develop a 200 – 300 word answer supporting your position.Guided Response: Review several of your peers’ postings and critique their analysis. Respond to at least two of your classmates by comparing the similarities and differences of your analysis. Why do you think the responses were either similar or different?—————————1. Rebekah.Explain CAPM and Measuring Risks and Return Capital Asset Pricing Model (CAPM) can be used to define the rate of return and risk; however, this model has disadvantages. O’Sullivan (2018) noted that the model has been disparaged as nothing is truly risk-free but with this model the risk is not known. Also, it is noted that when calculating with the CAPM the rate of return is not known in the given market (Byrd, Hickman, & McPherson, 2013). Since the CAPM is living in a theoretical space it can then be used to find the risk and rate of return using the stocks beta to find the market risk premium using the following formula, Required return for an investment = Rf + Beta[E(Rmkt) – Rf] (Byrd, Hickman, & McPherson, 2013). Using the formula and having some factors known, such as the yields for T-bonds and the past market risk premium, one can find the required rate of return (Byrd, Hickman, & McPherson, 2013). In other words, the CAPM is used to estimate what the returns could be in a given market. CAPM is often used in assess investments and inform stockholders on a possible return.CAPM and WACC Weighted average costs of capital (WACC) is a cumulative assessment using the costs in many areas noting what it would cost to get the capital funds desired. WACC is found by taking the cost of debt, stock, and equity (Byrd, Hickman, & McPherson, 2013). CAPM can assist in finding the value of equity needed for the formula. WACC is used to define the discount rate for a return and thus the use of CAPM is pivotal for accurate WACC.Difficulty Applying the Capital Asset Pricing Model (CAPM) in Decisions CAPM can pose challenges for financial decision making. O’Sullivan (2018) noted one of the issues with CAPM is that is pushing the idea that investors avoid risk and thus need returns to compensate them for the risk. While some may think this is true, without risk returns are often lowered. Because of this, CAPM may lead decision-makers to be thinking the lower risk is better when in actuality they could be missing out on higher returns due to the impossibility of a risk-free scenario. In other words, if one does not take the chance and keeps their money locked up instead of investing, they will not lose money nor will they gain. CAPM can provide misleading results that can have decision-makers working off inaccurate projections.Benefits and Drawbacks of CAPM As with any method, CAPM has both benefits and drawback to the use. The benefits of CAPM are that it allows for one to assess possible returns based on historical market trends. AS noted, WACC needs CAPM to assist in defining the equity for a company. A drawback for CAPM can be the misconception of risk aversion as a universal truth. Also, O’Sullivan (2018) expressed that human behavior cannot be predicated as tightly as this since many factors will change the results of one’s behavior meaning that the same unknown factors will influence the result of stocks in the market. In my view, the issue with CAPM is that it works heavily in theoretical and assumptions. However, one needs to have some guesses on how things will work when deciding in a risk-filled world. CAPM can be used to make decisions, but due to the drawback, it is not advisable to be the sole source of information to make decisions.Reference:Byrd, J., Hickman, K., & McPherson, M. (2013). Managerial finance. Retrieved from https://content.ashford.edu/O’Sullivan, P. (2018). The Capital Asset Pricing Model and the efficient markets hypothesis: The compelling fairy tale of contemporary financial economics. International Journal of Political Economy, 47(3/4), 225–252.————————-2. Simone.Financial managers need to know the expected rate of return that investors require to invest in a project or financial asset so that they can evaluate which projects to pursue (Jagannathan & McGrattan, 1995). The CAPM helps them accomplish this. “The CAPM is an equation that quantifies the relationship between an investor’s required rate of return and the risk of an investment” (Byrd, Hickman, & McPherson, 2013, s. 7.2). The WACC is the weighted average of the required returns for each source of capital and the only source of capital that is common among companies is common equity (Byrd, Hickman, & McPherson, 2013). CAPM is the most popular way companies determine their cost of equity and therefore assists in calculating the WACC (Byrd, Hickman, & McPherson, 2013).Some managers have difficulty applying the CAPM because there are some unknown variables that the CAPM needs to utilize in its equation. For example, “no one knows what the expected return on the market is equal to and the CAPM assumes that there is a single, observable risk-free rate when there is no investment devoid of risk” (Byrd, Hickman, & McPherson, 2013, s. 7.2). The benefits of using the CAPM are that it provides an estimate of the relationship between the riskiness of cash flows from a project and the cost of capital (Jagannathan & McGrattan, 1995). It is also simple in the sense that it does not require managers to conduct an extensive financial analysis of the company to answer its equation (Perold, 2004). Its drawbacks are that it is subjective and based on an idealized reality. CAPM assumes that (1) all investors are risk averse, (2) capital markets are perfect because information is available to everyone, (3) all investors have access to the same investment opportunities, and (4) all investors make the same estimates of expected returns (Perold, 2004).ReferencesByrd, J., Hickman, K., & McPherson, M. (2013). Managerial Finance [Electronic version]. Retrieved from https://content.ashford.edu/Jagannathan, R., & McGrattan, E. R. (1995). The CAPM debate. Federal Reserve Bank of Minneapolis.Quarterly Review – Federal Reserve Bank of Minneapolis, 19(4), 2. Retrieved from https://search-proquest-com.proxy-library.ashford.edu/docview/227763600?accountid=32521Perold, A. F. (2004). The capital asset pricing model. The Journal of Economic Perspectives, 18(3), 3-24. Retrieved from https://search-proquest-com.proxy-library.ashford.edu/docview/212070448?accountid=32521——————-Required ResourcesTextByrd, J., Hickman, K., & McPherson, M. (2013). Managerial finance [Electronic version]. Retrieved from https://content.ashford.edu/Chapter 7: Required ReturnsChapter 8: Cost of CapitalMultimediaBusinessQldGov. (2014, April 10). Identifying business risk – Risk management series [Video file]. Retrieved from https://www.youtube.com/watch?v=cZwyIPGhF_UAccessibility StatementPrivacy Policy
