Evaluating equity capital expenses is a key responsibility of a corporate financial planner. However, estimations of equity costs frequently leave one scratching their heads. The conclusions are also vulnerable to change, making their validity as benchmarks for comparison ambiguous. It outlines a technique for obtaining these numbers, a technique that was developed in the elitist world of financial theory. The capital investment pricing model (CAPM) perfectly captures how markets determine investment prices. With the use of this model, one can estimate returns on equity by quantifying risks and converting them into returns.



What is CAPM?


A financial model called the Capital Asset Pricing Model (CAPM) explains how risk and anticipated return for assets, particularly equities, relate to one another. The model is used to establish a hypothetically reasonable needed rate of return for an asset, given that asset's non-diversifiable risk, if that asset is to be added to an existing well-diversified portfolio. R i is the expected return on the asset, R f is the risk-free rate, I is the asset's beta, and R m is the expected return on the market. These terms are used in the CAPM calculation as R i = R f + beta i(R m - R f).


Generalized asset pricing model


A Generalized Asset Pricing Model (GAPM) is an extension of the Capital Asset Pricing Model (CAPM) that allows for the consideration of additional factors that may affect the expected return of an asset. These factors can include additional risk factors beyond just the market risk captured by the CAPM's beta, as well as other factors such as liquidity, size, value, momentum, and volatility. The GAPM allows for a more comprehensive analysis of the expected return on an asset, and can be used to determine a theoretically appropriate required rate of return for an asset when added to a well-diversified portfolio.



Does CAPM work?



Even though the Capital Asset Pricing Model (CAPM) is a widely used financial model, there is a great deal of debate about how well it can forecast actual returns on investments. While some studies have found evidence to support the CAPM, others have shown that the model does not stand up well in actual use. Certain assumptions made by the CAPM have drawn criticism, including the notions that there is only one risk-free rate, all investors have similar risk preferences and time horizons, and that investors can borrow and lend money at the risk-free rate.


Empirical research has also revealed that additional elements, like as size, value, momentum, and volatility, are crucial in understanding the return of a company and that the CAPM does not fully explain the cross-section of average returns.

The CAPM has its limits and should only be used with care, despite being a frequently used financial model. The projected return on an asset can be estimated using this as a starting point, but it shouldn't be the only factor considered when making an investment.


Tell me the asset pricing model?


A mathematical model known as an asset pricing model explains the connection between the risk and anticipated return of a financial instrument, such as a stock or bond. The Capital Asset Pricing Model is the most well-known and often employed asset pricing model (CAPM). The CAPM explains the connection between an asset's projected return and risk as determined by its beta, or how sensitive its return is to market conditions as a whole.

The formula for the CAPM is: R_i = R_f + \beta_i(R_m - R_f)

Where:

R_i = expected return on the asset
R_f = risk-free rate
\beta_i = the asset's beta
R_m = expected return on the market


Other asset pricing models have also been created, including multi-factor models like the Fama-French Three Factor Model, APT, ICAPM, and GAPM that take into account other variables including size, value, momentum, and volatility that may have an impact on an asset's projected return.

With regard to an asset's non-verifiable risk and an already well-diversified portfolio, these models are used to establish the theoretically suitable needed rate of return.

Tell me the best way to use it?


A popular financial model for estimating an asset's expected return given its level of risk is the capital asset pricing model (CAPM). The information available and the individual context will determine the best strategy to use the CAPM, but generally speaking, the steps below can be taken:

  • Calculate the projected return on the market (Rm): This can be done either by utilizing a forward-looking estimate based on current economic conditions and expectations or by looking at historical returns on a wide market index, such as the S&P 500.
  • Calculate the risk-free rate (Rf) by: An investor can anticipate earning this return on a risk-free investment, such as a Treasury bond. An approximation of the risk-free rate can be made using the current yield on a long-term Treasury bond.
  • Determine the asset's beta (): The asset's beta gauges its market-relative volatility. A beta value of 1 indicates that an asset's returns are highly connected with the market; a beta value below 1 indicates that an asset is less risky than the market, and a beta value over 1 indicates that an asset is riskier than the market.
  • Use the CAPM algorithm to determine the expected return on the asset (Ri): R m - R f = R i = R f + I
  • Comparing the computed expected return on the asset (Ri) to the investor's or the portfolio's needed return: It can be an excellent investment opportunity if the computed return is higher than the necessary return.
It's crucial to remember that the CAPM should not be the only instrument utilized when making investment decisions because it has its limits. In addition to the CAPM, other variables including size, value, momentum, and volatility should be taken into account to gain a more complete picture of the asset's predicted return.


Types of asset pricing models



There are several types of asset pricing models that have been developed to explain the relationship between risk and expected return for financial assets. Some of the most widely used models include:

  1. Capital Asset Pricing Model (CAPM): The CAPM is the most widely known and used asset pricing model. It describes the relationship between the expected return on an asset and its risk as measured by its beta, which is the sensitivity of the asset's return to the overall market.
  2. Multi-factor models: Multi-factor models extend the CAPM by taking into account additional risk factors beyond just the market risk captured by beta. For example, the Fama-French Three-Factor Model adds size and value factors, while the Carhart Four-Factor Model adds momentum factor.
  3. Arbitrage Pricing Theory (APT): According to the APT model, a number of characteristics unique to the asset and the market environment affect the projected return on an asset. The CAPM only considers one risk factor, but the APT model allows for a variety of variables that can influence expected return.
  4. Inter temporal Capital Asset Pricing Model (ICAPM): The ICAPM extends the CAPM to take into account both the fact that investors have various investment horizons and the fact that expected returns fluctuate with time.
  5. The Capital Asset Pricing Model (CAPM) is an expansion known as the Generalized Asset Pricing Model (GAPM), which allows for the consideration of extra factors that may have an impact on an asset's expected return. These variables may include not only the market risk that is accounted for by the CAPM's beta, but also variables like liquidity, size, value, momentum, and volatility.

Equation of a Straight Line


The equation of a straight line is y = mx + b.

In this equation:
  • y is the dependent variable (or the variable being plotted on the vertical or y-axis)
  • x is the independent variable (or the variable being plotted on the horizontal or x-axis)
  • m is the slope of the line (or the ratio of the change in y to the change in x)
  • b is the y-intercept (or the point at which the line crosses the y-axis)

For example, if we have a line with a slope of 2 and a y-intercept of 1, the equation of the line would be y = 2x + 1. This means that for every unit increase in x, y will increase by 2 units and the line will cross y-axis at 1.

It's important to note that the equation of a straight line is only valid if the data follows a linear relationship, if it is not linear, a different model should be used to represent the data.


Two types of risk

In finance and investment, there are generally two types of risk that investors must consider:

  • Systematic Risk: Systematic risk, also known as market risk or non-verifiable risk, is the risk that is inherent to the entire market and affects all investments within that market. Factors that can contribute to systematic risk include economic conditions, government policies, and natural disasters. This type of risk cannot be diversified away by holding a well-diversified portfolio.
  • Unsystematic Risk: Unsystematic risk, also known as specific risk or verifiable risk, is the risk that is specific to a particular company, industry or sector. Factors that can contribute to unsystematic risk include management decisions, competition, and technological developments. This type of risk can be diversified away by holding a well-diversified portfolio.
It's important to note that by diversifying a portfolio investors can mitigate unsystematic risk but not systematic risk.


Dividend growth model



The Dividend Growth Model (DGM) is a financial model that is used to estimate the intrinsic value of a stock based on the stock's dividends. The model is based on the assumption that the value of a stock is equal to the present value of all future dividends.

The formula for the Dividend Growth Model is:

P = (D1/(r-g)) + (D2/(r-g)^2) + (D3/(r-g)^3) + ... + (Dn/(r-g)^n)

Where:

P = the intrinsic value of the stock
D1, D2, D3, ..., Dn = the dividends for the next n periods
r = the required rate of return or the discount rate
g = the long-term growth rate of dividends


The premise of the dividend growth model is that investors will pay more for a stock that pays dividends and has a track record of raising dividends.

The DGM is a straightforward yet effective stock valuation model. It can be used to calculate a stock's intrinsic value, but it has several drawbacks. The model does not take into account changes in the economic environment, unforeseen occurrences, or any other factors that can effect the dividends because it assumes a constant growth rate of dividends, which is not always the case. Additionally, the DGM is inappropriate for some businesses because they do not pay any dividends.



Perfect information  CAPM


The Capital Asset Pricing Model (CAPM) is a theoretical framework that describes the relationship between risk and expected return for assets, particularly stocks. The CAPM assumes that markets are efficient and that investors have access to all relevant information, known as "perfect information." Under this assumption, the expected return of a stock is equal to the risk-free rate plus a risk premium that is proportional to the stock's systematic risk (also known as non-diversifiable or market risk) as measured by the stock's beta coefficient.