Question

Critically analyze the merits and demerits of the Capital Asset Pricing Model (CAPM) and discuss its value in practice.

Answer 1

Advantages:

1. It assists in eliminating unsystematic risk since it assumes that the investor holds a diversified portfolio.

2. It is a better model to calculate the cost of equity than other models since it considers the systematic risk as a whole.

3. The discounting rate provided by CAPM is far superior than other means.

Disadvantages:

1. CAPM model has too many assumptions which may not be practical to apply in all situations.

2. The variables used in CAPM have to calculated with utmost care and accuracy else it my give unrealistic rate of return.

3. One of the major assumptions of CAPM is that funds can be lent and borrowed at risk free rate and the same may not valid in the current economic situations.

4. Also, it ignores unsystematic risk and assumes that it can be diversified away which does not make it a comprehensive method.

CAPM is widely used in practice to calculate the cost of equity or cost of investment for a project since it is by far the easiest and useful method to estimate the required rate of return. It also is used to estimate if a stock is undervalued or overvalued based on the rate of return of the stock thereby letting investors take prudent decisions.