The widely used capital asset pricing model (CAPM)—when put into practice—has both pros and cons.
CAPM Model: An Overview
The capital asset pricing model (CAPM) is a finance theory that establishes a linear relationship between the required return on an investment and risk. The model is based on the relationship between an asset's beta, the risk-free rate (typically the Treasury bill rate) and the equity risk premium, or the expected return on the market minus the risk-free rate.
At the heart of the model are its underlying assumptions, which many criticize as being unrealistic and which might provide the basis for some of its major drawbacks. No model is perfect, but each should have a few characteristics that make it useful and applicable.
Advantages of CAPM Model
There are numerous advantages to the application of CAPM, including:
Ease of Use
CAPM is a simple calculation that can be easily stress-tested to derive a range of possible outcomes to provide confidence around the required rates of return.
- CAPM is a widely-used return model that is easily calculated and stress-tested.
- It is criticized for its unrealistic assumptions.
- Despite these criticisms, CAPM provides a more useful outcome than either the DDM or WACC models in many situations.
The assumption that investors hold a diversified portfolio, similar to the market portfolio, eliminates unsystematic (specific) risk.
CAPM takes into account systematic risk (beta), which is left out of other return models, such as the dividend discount model (DDM). Systematic or market risk is an important variable because it is unforeseen and, for that reason, often cannot be completely mitigated.
Business and Financial Risk Variability
When businesses investigate opportunities, if the business mix and financing differ from the current business, then other required return calculations, like the weighted average cost of capital (WACC), cannot be used. However, CAPM can.
[Important: When used in conjunction with other aspects of an investment mosaic, CAPM can provide unparalleled yield data that can support or eliminate a potential investment.]
Disadvantages of CAPM Model
Like many scientific models, CAPM has its drawbacks. The primary drawbacks are reflected in the model's inputs and assumptions, including:
Risk-Free Rate (Rf)
Return on the Market (Rm)
The return on the market can be described as the sum of the capital gains and dividends for the market. A problem arises when, at any given time, the market return can be negative. As a result, a long-term market return is utilized to smooth the return. Another issue is that these returns are backward-looking and may not be representative of future market returns.
Ability to Borrow at a Risk-Free Rate
CAPM is built on four major assumptions, including one that reflects an unrealistic real-world picture. This assumption—that investors can borrow and lend at a risk-free rate—is unattainable in reality. Individual investors are unable to borrow (or lend) at the same rate as the U.S. government. Therefore, the minimum required return line might actually be less steep (provide a lower return) than the model calculates.
Determination of Project Proxy Beta
Businesses that use CAPM to assess an investment need to find a beta reflective to the project or investment. Often, a proxy beta is necessary. However, accurately determining one to properly assess the project is difficult and can affect the reliability of the outcome.