You might have heard the term CAPM in the world of finance and might have often wondered what it is. But I know that you must not have thought about learning about that on a serious note. But Business and Finance assignments have a way of changing all that. Learn what CAPM is and why is it important for assignments.
Hi, I am Andy. I am a finance assignment help expert at Assignment Help Era and I am going to tell you how what CAPM is and how it is used in assignments.
Let us start with the basics first. What is CAPM?
Anyone? Jess, do you know what CAPM is? Jacob? Nobody? No worries.
CAPM is an abbreviation for Capital Asset Pricing Model. It is used to see how much return can an asset generate with systematic risks. CAPM has all the elements a hardcore finance assignment has.
Capital, in finance, means any economic resource which can give you money.
An asset is a finance term which means all the resources that the business owns.
Pricing, by default, smells of finance.
CAPM is widely used throughout finance for pricing risky securities and generating expected returns for assets given the risk of those assets and cost of capital.
Finance is incomplete without mathematical elements. The formula to calculate CAPM is
What do all these weird looking symbols mean?
ERi = Expected return of investment
Rf = Risk-free rate
?i = Beta of the investment
ERm = Expected return of the market
(ERm - Rf) = Market risk premium
What do these symbols actually mean?
Every investment has an investor who is offering you financial support. When an investor is giving you money, they expect that there will be sufficient compensation policy to account for the risk they are taking and the time value of money.
Do you see the risk-free rate in the formula above?
Yes, the Rf. That is the time value of money. Now you might be wondering what are those other symbols? They are the additional risk factors that the investor is taking.
Then there is a beta of a potential investment.
It is a measure of how much risk the investment will add to a portfolio that looks like the market. When the market is stable and the stock is riskier, the beta of potential investment will be greater than one. If a stock has a beta of less than one, the formula says that the investment will reduce the risk of a portfolio.
The story of beta doesn’t end here.
Once the stock’s beta has been calculated, it is then multiplied by the market risk premium, which is the return expected from the market above the risk-free rate.
What happens to the risk-free rate?
The risk-free rate is then added to the product of the stock’s beta and the market risk premium. The result should give an investor the required return or discount rate they can use to find the value of an asset.
Let me explain the entire story through an example.
I am an investor who is looking to invest in stock worth $100 per share right now. Let us say that the annual dividend is 3%.
The beta compared to the market is 1.3, which means that the stock is riskier than the market.
The risk free rate is also 3% and the market is expected to rise up by 8% every year. So, the CAPM formula will be -
CAPM = risk free rate + beta(expected return - risk free rate)
CAPM = 3% + 1.3(8%-3%)
CAPM = 9.5%
What does this CAPM of 9.5% means?
The value of the CAPM formula is 9.5%. This means that when I invest in that particular stock, I can expect an annual return of the stock of 9.5%.
What to do with this CAPM return value?
The value that you obtained is the expected return of the security. This is used to discount the expected dividends and capital appreciation of the stock over the expected holding period.
If the discounted value of those future cash flows is equal to $100 then the CAPM formula indicates the stock is fairly valued relative to risk.
Why are you studying CAPM in marketing course?
CAPM is a part of Accounting. It doesn’t matter if you are a business analyst in an organisation or a marketing analyst, being aware of the investment risks is always beneficial to your profession.
Moreover, there have been a lot of instances when marketing students have to predict the performance of stocks in their assignment solutions. And for that, the best tool to use is CAPM.
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