The Capital Asset Pricing Model is a powerful technique in the estimation of risk of a particular security. It nevertheless is not applicable in the real world due to its many limiting assumptions. Discuss the above statement.

Advanced Financial Management Block Revision Mock Exams

(a) CAPM

1. It provides the market based means of measuring risks and relating them to the well diversified well market portfolio.

2. It states/indicates why only systematic risk is relevant in project appraisal. The unsystematic risk can be completely eliminated through diversification.

3. The variables required for its operational use are easily obtainable.

4. It is one of the best means of establishing risk adjusted discount rate on computation of Ks or required rate of return.

1. It is strictly a single period model and must be used with caution in evaluation of multi period projects.

2. It only concentrate on the systematic risks and ignores other elements of risks (unsystematic risks) which may be relevant to the non-diversified investors.

3. The input data required for its operational use may be quite difficult to obtain practice e.g Ks, Bi required rate of return.

4. This model has been found not to perform in some instances e.g stocks with strong seasonality patterns.

5. The model only considers the level of return (total returns) and not the manner in which the returns are distributed (discussion on dividend theories or policies suggests that investors may prefer the packaging of the return i.e can either prefer dividends or capital gain).

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