Much research has focused on relaxing these restrictive assumptions. The experienced financial executive may have difficulty recognizing the world postulated by this theory. Finally, investors are assumed to agree on the likely performance and risk of securities, based on a common time horizon. The model also requires limiting assumptions concerning the statistical nature of securities returns and investors’ preferences. These include frictionless markets without imperfections like transaction costs, taxes, and restrictions on borrowing and short selling. In addition, the hypothetical investors of modern financial theory demand a premium in the form of higher expected returns for the risks they assume.Īlthough these two assumptions constitute the cornerstones of modern financial theory, the formal development of CAPM involves other, more specialized limiting assumptions. The second assumption describes investors who care about wealth and prefer more to less. The first assumption presumes a financial market populated by highly sophisticated, well-informed buyers and sellers.

Modern financial theory rests on two assumptions: (1) securities markets are very competitive and efficient (that is, relevant information about the companies is quickly and universally distributed and absorbed) (2) these markets are dominated by rational, risk-averse investors, who seek to maximize satisfaction from returns on their investments. Even so, finding answers to the questions requires an investment of time to understand the theory underlying CAPM. But in addressing the above questions I shall focus exclusively on its simple version. The burgeoning work on the theory and application of CAPM has produced many sophisticated, often highly complex extensions of the simple model. Despite limitations, the model can be a useful addition to the financial manager’s analytical tool kit. For financial executives, the proliferation of CAPM applications raises these questions: What is CAPM? How can they use the model? Most important, does it work?ĬAPM, a theoretical representation of the behavior of financial markets, can be employed in estimating a company’s cost of equity capital. CAPM, the capital asset pricing model, embodies the theory. The response promises to be no less heated. And increasingly, problems in corporate finance are also benefiting from the same techniques. But financial managers can use it to supplement other techniques and their own judgment in their attempts to develop realistic and useful cost of equity calculations.Īlthough its application continues to spark vigorous debate, modern financial theory is now applied as a matter of course to investment management. CAPM cannot be used in isolation because it necessarily simplifies the world of financial markets. The model provides a methodology for quantifying risk and translating that risk into estimates of expected return on equity.Ī principal advantage of CAPM is the objective nature of the estimated costs of equity that the model can yield. The capital asset pricing model (CAPM) is an idealized portrayal of how financial markets price securities and thereby determine expected returns on capital investments.

This article describes a method for arriving at that figure, a method spawned in the rarefied atmosphere of financial theory. But estimating the cost of equity causes a lot of head scratching often the result is subjective and therefore open to question as a reliable benchmark. An important task of the corporate financial manager is measurement of the company’s cost of equity capital.

Capital asset pricing model