Introduction

Capital asset pricing model (CAPM) is a fundamental financial model which describes the relationship between the expected return and the risk associated with pricing of most risky securities in the economy. The capital asset pricing model was first published in 1964 by William Sharpe. According to this model, the investors expect to be compensated through risk and time value of money of the assets chosen (Raiborn, 2009). The model is of great importance to the investors as it assists them to identify an asset with a high rate of return in order for it to be added into well diversified assets since most of the assets are considered to have non-diversified risk. The model calculates the required rate of return for asset investment based on its risk measurement. In order to attain this objective, the model uses a risk multiplier such as a beta coefficient (Anne, 2013). Just like all other models of finance, capital pricing model is usually based on assumptions. The work will present brief explanation of capital asset pricing model history, the pro and cons, analysis of new models that have been added to the CAPM to improve the data and show how the new models are completely different from CAPM.

Assumptions of CAPM

The model assumes that during the investment process there are no transaction costs and taxes do exists. It assumes that the lenders and the borrowers can lend and borrow unlimited huge amount of money at a zero risk rate (Macher, 2006). Moreover, it believes that the investors are the wealth maximizes who normally select their investment based on the standard deviation and expected return. The model assumes that there should be no restrictions to the short sales of the financial assets. Furthermore, the model believes that all the investors in the economy have the same expectations which are related to the market. The model goes ahead to assume that the quantities of all financial assets are usually fixed and given as no investors activities might influence market prices (Hoffmann, 2008). Nevertheless, some of these assumptions of the capital asset pricing model do not work in the real investment model  although some still work efficiently in selection of diversified asset which might be included into the other diversified portfolios get its rate of return.

The Advantages and disadvantages of CAPM

Capital asset pricing model is believed to have more advantages as compared to other methods which are used in calculation of the rate of return and the risk of a given portfolio to be selected and combined with the already existing portfolios. The capital asset pricing model is considered to be superior to the weighted average cost of capital in the process of providing the discounted rates of return that is to be used in the investment appraisal. It is a better approach for calculating the cost of equity than the dividend growth model because it openly takes into account the organization level of systematic risk that is relative to the stock market as a whole (Douglas, 2011). The model normally generates a theoretic derived relationship between the systematic risk and required return which is subjected to the frequent empirical testing and empirical. The model is also of great importance because it considers systematic risks which reflect on the reality of investment which the investors might depend in order to eliminated the portfolios in their investment with the highest unsystematic risks.

Just like any other model in existence, capital asset pricing model usually suffers from a number of limitations and disadvantages. The disadvantage and the limitations of this model is that in order for the model to be used efficiently and effective it would be important for the investor to assign the CAPM values to the already predetermined risk free rate of return, equity risk premium, equity beta and the return on the market (Dawson, 2004). The yield on the short term government debt that is used by the investors as a risk free rate of return is usually flexible and changes frequently according to the current economic circumstances. It is always difficult to determine the value of equity risk premium (ERP).

As a matter of fact, the return from the stock market is usually the sum of both average dividend yield and the average capital gain. In the modern times, the uncertainly of the expected return and arises because the values of Beta are flexible and changes over time. Furthermore, it is always difficult to establish a suitable proxy beta because different organizations in the economy usually undertake only a single business activity. It is also difficult to use a fixed companies Beta because their capital structure information is not readily available (Elton, 2010). Some of the companies in existence are believed to have complex capital structures with various sources of capital hence making it difficult for the investors to establish the beta and appropriate asset for investment. The model assumption of a single period time horizon is in contrast with the multiple period of investment appraisal which is considered by other models such as the weighted cost of capital.

Other new models which might be added to CAPM to improve models and data

Weighted average cost of capital (WACC) is a model which is used to calculate a company’s cost of capital where each class of capital is suitably weighted. According to the model, all the sources of capital such as the bonds, preferred stock, long term debt and common stock are used in the calculation of the weighted cost of capital (Damodaran, 2012). The model assumes that the rate of return and the beta on equity usually increases as the values of WACC increase.  In comparison to the capital asset pricing model which has a fixed beta for calculating the expected rate of return from an investment, the weighted cost of capital depend on the average rate of return which is obtained after the combination of the various cost of capital in the organization.

The assumptions of the weighted cost of capital (WACC) include: the lenders of the finances do not change their required rate of return because the results of the investment project are usually undertaken, the investment organization is considered to be larger than the investment project, the business activities of both investment project and organization are considered to be similar (Kumar, 2010). In addition, the model assumes that the financial mix and capital structure used in undertaking the new investment is similar to the existing financing structure in an organization. These assumptions suggest that WACC can be used as a discounted rate of return as long as the investment to be undertaken does not change the financial and business risk (Daft, 2010). In case the financial risk of the business or financial investment to be undertaken is different from the one of the organization investing, it is appropriate for the investors to use the capital asset pricing model in calculating the specific discount rate. WACC is of great importance for the investor in determining the appropriate project to invest in especially when an investor is on a dilemma of choosing one investment. The use of WACC model assists the investors to calculate each project specific discounted rate of return hence an appropriate way of selecting the best project for investment. Just in case the internal rate of return of a project is lower than the weighted cost of capital then, the project shall be rejected.

The investors might also use the multi Beta model in making decision in regard to the asset with the highest return as well as lower risks. The arbitrage pricing model allows the use of multiple sources of market risk to be considered while comparing them with the required rate of return from the investment and the betas of each asset are compared with each other (Wu, Hung-Yi, 2012). The multifactor model usually uses the historical data and relates it to specific macro economic factors such as the slope of the yield curve, level of interest rate and the GDP growth and determines the betas of each and every organization against these variables. The investors may also end up using the market price based models to establish an appropriate asset to invest in based on it rate of return and risk. In other instances especially in the modern times, investors are believed to select the kind of asset to invest in using the accounting information based models (David, 2014). The investors usually select the asset to invest in and calculate the accounting ratio and establish a scaled risk measurement ration to which the asset shall be based.

Conclusion

Despite the fact that there are various models which might be used by the investors in calculating the rate of return and the risks associated with the assets to be selected for investment, it is always important to select the best method which meets the investors’ expectation (Bartlett & Beamish, 2013). Capital pricing model despite being an old model in the calculation of the risk and the required rate of return for an asset, it is considered to be the best model which the investor might us in making decision on the assets to select. As compared to the weighted average cost of capital and accounting information pricing model, CAPM is seen to be simple to calculate and workable in most of the economic sectors