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Hello everyone,

The Capital Asset Pricing Model (CAPM) is still one of the most important tools in corporate finance. It gives you a simple but effective way to figure out an investment's projected return based on its systematic risk. This week's discussion on CAPM brought out its three main ideas: investors can borrow and give at a risk-free rate, all investors have efficient portfolios, and all investors have the same expectations (Berk & DeMarzo, 2017). Even though these assumptions don't always hold in the real world, CAPM is still a useful tool for figuring out needed rates of return for capital budgeting and valuation and for understanding the tradeoffs between risk and return.

Finding a company's cost of equity, which is a big part of the Weighted Average Cost of Capital (WACC), is one of the most important things that CAPM can be used for. WACC is an important tool for figuring out which investment opportunities are the best for the company in terms of overall risk. Using similar all-equity companies and the process of unlevering and relevering beta can help account for different capital structures.

The Economist (2024) says that many investors are rethinking how much of a premium they need above the risk-free rate to support investing in stocks because tech and emerging markets are becoming more volatile. Even though it is simplified, CAPM helps institutional investors and CFOs set goals for success and understand what customers expect. Critics also say that CAPM theories are wrong when it comes to how real investors act, such as when they follow the crowd or are too sure of themselves. However, the model is still useful when it comes to making sure that data is consistent and easy to compare.

Still, a lot of experts agree that CAPM doesn't take into account all the factors that affect how well stocks do. The Fama-French-Carhart multifactor model, which has momentum, growth, and value factors, can explain things better. Barron(2023) says that even this model has trouble when the economy as a whole changes or when investor sentiment gets in the way of facts.

-Tanisha

Reference

Berk, J., & DeMarzo, P. (2017). Corporate Finance (4th ed.). Pearson.

Brealey, R. A., Myers, S. C., & Allen, F. (2011). Principles of Corporate Finance, Concise Edition (2nd ed.). McGraw-Hill Irwin.

The Economist. (2024, February). Investors Rethink Risk Premiums in a Volatile Market.

Barron's. (2023, October). Factor Investing: Where CAPM Falls Short.

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