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THE CAPITAL ASSET PRICING MODEL

RELEVANT TO ACCA QUALIFICATION PAPER F9

Section F of the Study Guide for Paper F9 contains several references to the capital asset pricing

model (CAPM). This article is the last in a series of three, and looks at the theory, advantages,

and disadvantages of the CAPM. The first article, published in the January 2008 issue of student

accountant introduced the CAPM and its components, showed how the model can be used to

estimate the cost of equity, and introduced the asset beta formula. The second article, published in

the April 2008 issue, looked at applying the CAPM to calculate a project-specific discount rate to use

in investment appraisal.

CAPM FORMULA

Investors hold diversified portfolios

following: that there are no taxes or transaction

The linear relationship between the return

This assumption means that investors will only

costs; that perfect information is freely available

required on an investment (whether in stock

require a return for the systematic risk of their

to all investors who, as a result, have the same

market securities or in business operations)

portfolios, since unsystematic risk has been

expectations; that all investors are risk averse,

and its systematic risk is represented by the

removed and can be ignored.

rational and desire to maximise their own utility;

CAPM formula, which is given in the Paper F9

i = beta value for financial asset i

E(rm) = average return on the capital market

Investors can borrow and lend at the risk-free rate Rm

of return

The CAPM is an important area of financial

This is an assumption made by portfolio theory,

management. In fact, it has even been suggested

from which the CAPM was developed, and provides Rf

that finance only became a fully-fledged, scientific a minimum level of return required by investors.

discipline when William Sharpe published his

The risk-free rate of return corresponds to the

derivation of the CAPM in 19861.

intersection of the security market line (SML) and

the y-axis (see Figure 1 ). The SML is a graphical

CAPM ASSUMPTIONS

representation of the CAPM formula.

While the assumptions made by the CAPM allow

The CAPM is often criticised as being unrealistic

it to focus on the relationship between return

because of the assumptions on which it is based,

Perfect capital market

and systematic risk, the idealised world created

so it is important to be aware of these assumptions This assumption means that all securities are

by the assumptions is not the same as the real

and the reasons why they are criticised. The

valued correctly and that their returns will plot on

world in which investment decisions are made by

assumptions are as follows2:

to the SML. A perfect capital market requires the

companies and individuals.

technical

linked performance objectives

performaNce obJectives 15 aNd 16 are reLevaNt to paper f9

For example, real-world capital markets are

clearly not perfect. Even though it can be argued

that well-developed stock markets do, in practice,

The assumption of a single-period transaction

horizon appears reasonable from a real-world

perspective, because even though many investors

hold securities for much longer than one year,

returns on securities are usually quoted on an

annual basis.

The assumption that investors hold diversified

portfolios means that all investors want to hold a

portfolio that reflects the stock market as a whole.

Although it is not possible to own the market

portfolio itself, it is quite easy and inexpensive

for investors to diversify away specific or

unsystematic risk and to construct portfolios that

track the stock market. Assuming that investors

are concerned only with receiving financial

compensation for systematic risk seems therefore

to be quite reasonable.

A more serious problem is that, in reality,

it is not possible for investors to borrow at the

risk-free rate (for which the yield on short-dated

Government debt is taken as a proxy). The reason

for this is that the risk associated with individual

investors is much higher than that associated with

the Government. This inability to borrow at the

risk-free rate means that the slope of the SML is

shallower in practice than in theory.

Overall, it seems reasonable to conclude that

while the assumptions of the CAPM represent

an idealised rather than real-world view, there

the investment project does not change either

This investment decision is also incorrect,

is a strong possibility, in reality, of a linear

the business risk or the financial risk of the

however, since project B would be rejected if

relationship existing between required return and

investing organisation.

using a CAPM-derived project-specific discount

systematic risk.

If the business risk of the investment project is rate, because the project IRR offers insufficient

different to that of the investing organisation, the

compensation for its level of systematic risk4.

CAPM can be used to calculate a project-specific

The weighted average cost of capital (WACC)

was covered in the second article in this series3.