AFMP4
Syllabus B3cd. The Cost of CapitalCost of equity

capm continued 3 / 5

CAPM continue

How risky is the specific investment compared to the market as a whole?

  1. This is the ‘beta’ of the investment If beta is 1, the investment has the same risk as the market overall.

  2. If beta > 1, the investment is riskier (more volatile) than the market and investors should demand a higher return than the market return to compensate for the additional risk.

  3. If beta < 1, the investment is less risky than the market and investors would be satisfied with a lower return than the market return.

Illustration

Risk free rate = 5% 

Market return + 14% 

What returns should be required from investments whose beta values are: 
(i) 1 
(ii) 2 
(iii) 0.5

  • Cost of Equity = Rf +beta(Rm - Rf) 

    (i)  = 5 + 1(14 - 5) = 14%    

    The return required from an investment with the same risk as the market, which is simply the market return.

  • (ii) = 5 + 2(14 - 5) = 23% 

    The return required from an investment with twice the risk as the market. 

    A higher return than that given by the market is therefore required.

  • (iii) = 5 + 0.5(14 - 5) = 9.5%
     
    The return required from an investment with half the risk as the market. 

    A lower return than that given by the market is therefore required.

CAPM assumptions

  1. Diversified investors

  2. Perfect market (in fact they are semi strong at best)

  3. Risk free return always available somewhere

  4. All investors expectations are the same

Advantages of CAPM

  1. The relationship between risk and return is market based

  2. Correctly looks at systematic risk only

  3. Good for appraising specific projects and works well in practice

Disadvantages of CAPM

  1. It presumes a well diversified investor . 

    Others, including managers and employees may well want to know about the unsystematic risk also

  2. The return level is only seen as important not the way in which it is given. 

    For example dividends and capital gains have different tax treatments which may be more or less beneficial to individuals.

  3. It focuses on one period only. 

    Some inputs are very difficult to get hold of. 

    For example beta needs a subjective analysis

  4. Generally CAPM overstates the required return for high beta shares and visa versa