Explain and state the assumptions used in the Capital Asset Pricing Model (CAPM) and how you would estimate the cost of equity of the required rate of return by the shareholders of the company using that CAPM.

A

It is normally found that investors are more concerned about their portfolio of total investments rather than the valuation of individual investments. Therefore, it is quite possible that one or two individual investments in the basket may be high risk and thus contribute to overall high risk. The Capital Asset Pricing Method (CAPM) is concerned about the mode of assessing individual stocks and how it could impinge total investments risks.
However, there are certain fundamental assumptions about CAPM. They are:

  • Investors are averse to risk-taking in their investment patterns
  • They have similar expectations about the rate of return of assets
  • It is the normal distribution that determines the return on assets
  • Assets are perfectly divisible

There are no market abnormalities like taxes, market behavior that could have material impacts.

The method in which the Beta coefficient is calculated using CAPM is based on expected values and not real values. This beta coefficient that is utilized by investors should show the expected movements of the given stock returns as against the returns on the market at a professed future period. In some cases, it is seen that CAPM is calculated using certain past data with the hypothesis that future trends would follow the past performance of stocks. Suppose the stock whose beta >1.0 is added to a b = 1.0 portfolio than this portfolio’s beta. Then the probability of risk would increase. Similarly, where beta< 1.0 is added to a b = 1.0 portfolio, its risk and beta would also decline.

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Academic.Tips. 2021. "Explain and state the assumptions used in the Capital Asset Pricing Model (CAPM) and how you would estimate the cost of equity of the required rate of return by the shareholders of the company using that CAPM." October 10, 2021. https://academic.tips/question/explain-and-state-the-assumptions-used-in-the-capital-asset-pricing-model-capm-and-how-you-would-estimate-the-cost-of-equity-of-the-required-rate-of-return-by-the-shareholders-of-the-company-using-t/.

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Academic.Tips. "Explain and state the assumptions used in the Capital Asset Pricing Model (CAPM) and how you would estimate the cost of equity of the required rate of return by the shareholders of the company using that CAPM." October 10, 2021. https://academic.tips/question/explain-and-state-the-assumptions-used-in-the-capital-asset-pricing-model-capm-and-how-you-would-estimate-the-cost-of-equity-of-the-required-rate-of-return-by-the-shareholders-of-the-company-using-t/.

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"Explain and state the assumptions used in the Capital Asset Pricing Model (CAPM) and how you would estimate the cost of equity of the required rate of return by the shareholders of the company using that CAPM." Academic.Tips, 10 Oct. 2021, academic.tips/question/explain-and-state-the-assumptions-used-in-the-capital-asset-pricing-model-capm-and-how-you-would-estimate-the-cost-of-equity-of-the-required-rate-of-return-by-the-shareholders-of-the-company-using-t/.

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