Briefly describe the Capital Asset Pricing Model and its use in investment opportunities.

Expert Solution

Capital Asset Pricing Model uses the asset pricing model theory that expected return on a stock is the sum of risk free rate and premium for taking that risk. Follwoing is the equation for CAPM:

Expected return on stock = Risk free rate + beta ( expected return on market - risk free rate)

Where, beta is the sensitivity os stock to changes in market return.

expected return on market - risk free rate is the risk premium

Risk free rate will be the yield on a default free government bond

CAPM is used to calculate the cost of equity which in turn se used in weighted average cost of capital to find the present value of investment oppurtunities. It based on the premise that investors have assumptions on systematic risks and they need to be compensated for taking systematic risks.

Use in investment oppurtunities:

CAPM is used for calculating cost of equity. Cost of equity is an integral part of weiighted average cost of capital which basically depicts return required by investors for investing in a project. WACC is used to find the net present value of an investment opportunity. It helps inevstors to determine whether a project is worth investing or not. It also used in finding enetrprise value. CAPM is also widely used in pricing risky assets.

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