capital asset pricing model

Examples of capital asset pricing model in the following topics:

• The Capital Asset Pricing Model

  • The capital asset pricing model helps investors assess the required rate of return on a given asset by measuring sensitivity to risk.
  • All this really means is that investors are on the look out for ways to minimize risk, maximize returns, and invest intelligently in assets that are well-priced.
  • When measuring the ratio between risk and return on a given investment, the capital asset pricing model (CAPM) can be a useful tool.
  • This model focuses on measuring a given asset's sensitivity to systematic risk (also referred to as market risk) in relation to the expected return compared to that of a theoretical risk-free asset.
  • Calculate sensitivity to risk on a theoretical asset using the CAPM equation

• The Relationship Between Risk and Return and the Security Market Line

  • In finance, the capital asset pricing model (CAPM) is used to determine the required rate of return of an asset, taking into account an asset's sensitivity to non-diversifiable or systematic risk.
  • Non-diversifiable risk is noted by the variable beta (β), where beta is greater than one if the asset's price sensitivity is greater than the market; equal to one when the asset's sensitivity is equal to the market; and less than one if the asset exhibits less pricing volatility than the market.
  • The CAPM is a model for pricing an individual security or portfolio.
  • Mathematically, the capital asset pricing model can be written as: E(Ri) = Rf + β(E(Rm) - Rf), where R is the return, E(R) is the expected return, i denotes any asset, f is the risk-free asset, and m is the market.
  • The SML essentially graphs the results from the capital asset pricing model formula.

• Valuing the Corporation

  • In addition to estimating the selling price of a business, the same valuation tools are often used by business appraisers to resolve disputes related to estate and gift taxation, divorce litigation, allocate business purchase price among business assets, establish a formula for estimating the value of partners' ownership interest for buy-sell agreements, and many other business and legal purposes.
  • The Capital Asset Pricing Model (CAPM) is one method of determining the appropriate discount rate in business valuations.
  • The Cost of Equity (Ke) is computed by using the Modified Capital Asset Pricing Model
  • The weighted average cost of capital is an approach used to determine a discount rate.
  • The market approach to business valuation is rooted in the economic principle of competition: that in a free market the supply and demand forces will drive the price of business assets to a certain equilibrium.

• Impact of the SML on the Cost of Capital

  • The plotted location of an instrument on the SML has consequences on its price, return, and cost of capital it contributes to a firm.
  • The security market line is a graphical representation of the capital asset pricing model that illustrates the idea that investments are priced efficiently based on the expected return and beta-value (risk).
  • A firm that is raising capital would like to sell these instruments for a high price, and investors want to buy them for a low price.
  • The rational investor will require either a higher return or lower price, which will both result in a higher cost of capital for the company.
  • Describe the impact of the SML on determining the cost of capital

• Relationship Between Financial Policy and the Cost of Capital

  • To analyze various options, managers use valuation techniques, such as the capital asset pricing model or discounted cash flow analysis.
  • Opportunity cost of capital is the amount of money foregone by investing in one asset compared to another.
  • For example, to the extent prices in the stock market move differently from prices in the bond market, a collection of both types of assets can, in theory, face lower overall risk than either could individually.
  • The capital structure of a company refers to the way it finances its assets through some combination of equity, debt, or hybrid securities.
  • The fluctuation of oil prices can be seen in the above graph.

• The SML Approach

  • The Security Market Line (SML) is the graphical representation of the capital asset pricing model (CAPM), with the x-axis representing the risk (beta), and the y-axis representing the expected return.
  • Individual assets that are correctly priced are plotted on the SML.
  • In the ideal world of CAPM, all assets are correctly priced and thus lie on the SML.
  • If an asset is priced above the SML, and thus undervalued, it should be bought.
  • If an asset is priced below the SML, and thus overvalued, it should be sold.

• Basic Components of Asset Valuation

  • Assets are valued using absolute value, relative value, or option pricing models, which require different inputs.
  • They would credit assets received as gifts to a stockholders' equity account titled Paid-in Capital—Donations.
  • These models rely on mathematics rather than price observation.
  • Relative value models determine value based on the observation of market prices of similar assets.
  • The most common option pricing models are the Black–Scholes-Merton models and lattice models.

• Finding an Equilibrium Exchange Rate

  • Like purchasing power parity, the balance of payments model focuses largely on tangible goods and services, ignoring the increasing role of global capital flows .
  • The increase in capital flows has given rise to the asset market model.
  • The asset market model views currencies as an important element in finding the equilibrium exchange rate.
  • Asset prices are influenced mostly by people's willingness to hold the existing quantities of assets, which in turn depends on their expectations on the future worth of the assets.
  • The asset market model of exchange rate determination states that the exchange rate between two currencies represents the price that just balances the relative supplies of, and demand for, assets denominated in those currencies.

• Valuation of Intangible Assets

  • The valuation of intangible assets are primarily derived from transactions involving intangible assets.
  • Valuation models can be used to value intangible assets such as patents, copyrights, software, trade secrets, and customer relationships.
  • As a result, present value models or estimating of the cost to recreate an intangible asset are often used to is these valuations.
  • Intangible assets are initially recorded on financial statements at their purchase price, or the cost of acquiring the asset.
  • If a company incurs legal costs to successfully defend an intangible asset, those costs are capitalized and increase the value of the intangible.

• Reporting

  • These capital gains are profits derived from the sale of investments, which is to say that existing investments where capital is still tied in the underlying asset it not taxable (though it must be reported on the balance sheet for organizations as assets).
  • As with most regulatory environments, it is not a one size fits all model.
  • The sale of an asset at a loss is often a tax deductible, as are other capital losses.
  • Donations of assets or capital to charity are tax deductible in most situations.
  • In such situations, the difference between the original price and the new price may be a source of tax deduction.