In: Economics

# Question 4 Describe the capital asset pricing model (CAPM) and how it is used in capital...

Question 4 Describe the capital asset pricing model (CAPM) and how it is used in capital budgeting decisions.

## Solutions

##### Expert Solution

The Capital Asset Pricing Model (CAPM) defines the connection between systematic risk, especially stocks, and anticipated return on investments. CAPM is commonly used throughout finance for pricing risky securities and producing anticipated asset yields due to the danger of such investments and capital costs.

Investors expect risk and time value of cash to be compensated. The risk-free rate reflects the time value of cash in the CAPM formula. Additional risk is taken from the other parts of the CAPM formula for the investor.

The beta of a prospective investment is a measure of how much danger the investment adds to a market-like portfolio. If a stock is more risky than the economy, it will have more than one beta. If a stock has less than one beta, the formula assumes the risk of a portfolio will be reduced.

The goal of the CAPM formula is to evaluate whether a stock is fairly valued when its risk and the time value of money are compared to its expected return.

The capital budgeting model (CAPM) is often used by corporate accountants and financial analysts to assess the price of shareholder equity. CAPM outlines the connection between systematic risk and anticipated asset return. It is commonly used for risky securities pricing, producing anticipated asset yields due to the related danger, and calculating capital expenses.

The CAPM formula requires only three pieces of information: the rate of return for the general market, the beta value of the stock in question, and the risk-free rate.

Ra=Rrf+[Ba∗(Rm−Rrf)]

The inventory beta relates to the individual security risk level relative to the wider market. A beta value of 1 shows inventory movements in tandem with market movements. If the Nasdaq benefits 5%, so does the safety of the person. A higher beta shows a more volatile inventory and a reduced beta shows higher stability.

The risk-free rate is generally defined as the rate of return on the short-term U.S. (more or less guaranteed). Treasury bills due to the highly stable value of this form of safety and the return is supported by the U.S. government. Therefore, the danger of losing money invested is nearly nil, and a certain amount of profit is guaranteed.

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