The paper 'The Project's Relevant Risk Features' is a wonderful example of a financial and accounting assignment. It's a model that gives you an apt expected cost of capital for each project, given the project's relevant risk features. Consequently, it clearly describes the correlation between risks with respect to the expected return. It's commonly used to establish pricing models for risky securities. CAPM is the most complicated method of establishing a risk-return relationship of a given individual security that will form part of a portfolio. According to CAPM, the total risk of a portfolio can be subdivided into systematic and unsystematic risk.
It further assumes that the investor holds an efficient portfolio i. e., all unsystematic risk has been diversified, and systematic risk (commonly denoted by a Beta factor) is the only prevailing risk. CAPM involves the following three aspects; Stock prices-these These are affected by both firm-specific and market-wide risks. However, most investors care for only non-diversifiable risk. Beta Factor- This is the risk measuring factor of non-diversifiable risk of stock i. e., a measure of the systematic risk. The beta factor of any portfolio refers to it's the weighted average of the individual securities. Expected or required returns- These are linear functions of betas (market premium) difficulties applying the model. Being a complicated method, most financial managers experience difficulties when applying the model due to the following factors; -It is difficult to measure a security's beta.
In investment appraisal, using CAPM raises difficulties that include the obtaining of proxy betas. The subjectivity of the beta poses a challenge. As a result, estimates that are derived for a firm may not be accurate, leading to poor decision making in the long run if not corrected in due time. -Secondly, the relationship between risk and return is a more complex matter than the simple linear relationship defined by the CAPM.
Theoretically, the model is very easy to understand, but when put to real situations, it becomes a headache. It thus requires strategic analysis for its maximum efficiency by the managers. -The assumption that all market participants have equal market power does not hold in practice. The model is based on the utopian assumption, which poses a big challenge when it comes to real-life capital decision making.
In reality, due to political interference and competitiveness, firms do not have equal market power. -It also assumes that the capital markets are perfect and efficient i. e., no transaction costs, no corporate & personal taxes, free flow of information in the market, and risk-averse investors. However, these assumptions are irrelevant in practice as capital markets are not perfect in the real world. - Another disadvantage is that the assumption of a single period time horizon is contrary to the multi-period nature of investment appraisal. -Finally, capital structure information that is needed in the ungearing of proxy betas is not usually readily available. T is a graphical representation showing the relationship between the expected return and risk using the measure of systematic risk.
The equation of the line is the equation of the CAPM i. e.; it is the graphical representation of CAPM. It helps show under or overpriced securities. If security lies above the SML, it's regarded as underpriced, and the converse is true.
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