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student accountant

JUNe/JULY 2008

CAPM: THEORY,

ADVANTAGES, AND

DISADVANTAGES

THE CAPITAL ASSET PRICING MODEL

RELEVANT TO ACCA QUALIFICATION PAPER F9

Section F of the Study Guide for Paper F9 contains several references to the capital asset pricing model (CAPM). This article is the last in a series of three, and looks at the theory, advantages, and disadvantages of the CAPM. The first article, published in the January 2008 issue of student accountant introduced the CAPM and its components, showed how the model can be used to estimate the cost of equity, and introduced the asset beta formula. The second article, published in the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use in investment appraisal.

CAPM FORMULA

The linear relationship between the return required on an investment (whether in stock market securities or in business operations) and its systematic risk is represented by the

CAPM formula, which is given in the Paper F9

Formulae Sheet:

E(ri) = Rf + βi(E(rm) - Rf)

E(ri) = return required on financial asset i

Rf = risk-free rate of return βi = beta value for financial asset i

E(rm) = average return on the capital market

The CAPM is an important area of financial management. In fact, it has even been suggested that finance only became ‘a fully-fledged, scientific discipline’ when William Sharpe published his derivation of the CAPM in 19861.

CAPM ASSUMPTIONS

The CAPM is often criticised as being unrealistic because of the assumptions on which it is based, so it is important to be aware of these assumptions and the reasons why they are criticised. The assumptions are as follows2:

Investors hold diversified portfolios

This assumption means that investors will only require a return for the systematic risk of their portfolios, since unsystematic risk has been removed and can be ignored.…...

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