Disscuss the relevance of the capital asset pricing model (CAPM) to a Essay - 1

Disscuss the relevance of the capital asset pricing model (CAPM) to a company seeking to evaluate its cost of capital - Essay Example The market risk or systematic risk is the unavoidable risk brought in by the economy wide perils (Brealy et al, 2005). The CAPM’s focus is on the method of measuring systematic risk and its effect on the required return and share prices. Though it was initially evolved for investment in equity, it is also used for evaluating company investments in capital projects now (Davis & Pain, 2002). Capital Asset Pricing Model (CAPM) attempts to bring out a linkage between risk and return for the assets (Gitman,2006). The CAPM is built on the premise that well diversified investors dominate the stock market and their paramount concern being the market risk. The assumption is plausible in a situation in which large institutions and small investors can diversify at a low cost (Brealy et al, 2007). The CAPM builds on the proposition that additional risk requires a higher return. This return has two components: (1) what may be earned on a risk-free asset, such as a U.S. Treasury bill, plus (2) a premium for bearing risk. Since unsystematic risk is reduced through diversification, a stock’s risk premium is the additional return required to bear the non-diversifiable, systematic risk associated with the stock (Mayo 2007). The key input for the CAPM is therefore the excess return of the market over the risk free rate, which is the market (equity) risk premium. The practice adopted commonly has been to apply the historical average return over a long period as a measure of what investors expect to earn. As a substitute for the market portfolio, a broad equity market index is applied. Ke is the cost of equity capital, Rf is the risk free rate of return usually measured by the rate of return on US treasury securities, Rm is the market return of a diversified portfolio and I is the Beta co-efficient of the firm’s portfolio. The beta coefficient shows the volatility of the stock relative to that of an average stock. If it is 0.5, it is half as