Essays on Capital Asset Pricing Model Case Study

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The paper 'Capital Asset Pricing Model' is a good example of a Finance and Accounting Case Study. The concept of risk and returns was not fundamental until the later 1960s when the first Capital Asset Pricing Model was developed. Measuring risk is an imperative practice especially for investors whose returns are coupled with economic and business uncertainties. To create investors’ confidence, the incorporation of risks in the computation of risk-adjusted returns has been the major focus for companies. Therefore, entities have invested efforts hugely in managing their internal operations to ensure that they report positive cash flows by mitigating or minimizing business risks.

Importantly, the rising concerns on business risks are due to the fact that they are firm-specific, unlike unsystematic risks. That said, empirical evidence regarding the validity and the usefulness of CAPM is more compelling than those that dwell on its limitations. Historical Account of CAPM The CAPM was first developed by Jack Treynor, who was a student at Haverford College in the early 1950s (Sullivan, 2006: Perold, 2004). The genesis of the evolution of the CAPM and the calculation of returns and risks using quite sophisticated methods began in the early 1950s when Harry Markowitz found the theory of investor preference.

His empirical proposition in the theory was that the investors had the choice to make the decision of combining stocks-what is now referred to us the portfolio. Harry believed that investors could establish a portfolio so as to trade-off the risks and the returns. At this time, the portfolio risk and returns were computed to influence the investor’ s decision. Furthermore, in retrospect, the determination of the cost of an asset was assumed to largely dependent on the methodology used to value that asset and not the payout policies as seconded by Miller and Modigliani (DeAngelo and DeAngelo, 2006, 293).

When the technology advanced and the researchers were now able to collect and process data efficiently, William Sharpe, Jack Treynor, John Lintner, and Jan Mossin developed further the CAPM in 1960. Modern finance featured the determination of the cost of capital based on the amount of finance that a company has. This approach has received various criticism on the argument that the valuation of assets cannot only be based on the amount that was used to finance the asset.

The approach that Modigliani and Miller used concerning the valuation of business or calculation of the weighted cost of capital has been considered subjective since it hugely depends on the forecast of returns (Perold, 2004, 5). With the nature of the economic situation and markets that face different countries, then forecasting the cash flows and using it to calculate the expected returns was not attractive to investors. The CAPM was developed to facilitate the understanding of the relationship between risk and returns.

While economists Miller and Modigliani believed that the dividend policy was irrelevant when making investment decisions, Lintner believed that the financial policy of a company was very imperative in the determination of returns. The CAPM was backed up by the likes of William Sharpe, Lintner, and Mossin who have been credited for their contributions in the finance. Nonetheless, Jack came to be recognized in the recent generation since his failure to publish his work during those times made other contributors more famous.

Reference

List

Sullivan, E.J., 2006. A Brief History of the Capital Asset Pricing Model. Association of Pennsylvania University Business and Economic Faculties.

Perold, A.F., 2004. The capital asset pricing model. The Journal of Economic Perspectives, 18(3), pp.3-24.

DeAngelo, H. and DeAngelo, L., 2006. The irrelevance of the MM dividend irrelevance theorem. Journal of financial economics, 79(2), pp.293-315.

Galagedera, D.U., 2007. A review of capital asset pricing models. Managerial Finance, 33(10), pp.821-832.

Uhman, J. and Nepovolný, T., The problem of determining the WACC. http://uhman.cz/wp-content/uploads/2014/08/The-problem-of-determining-the-WACC.pdf

Dempsey, M., 2013. The capital asset pricing model (CAPM): the history of a failed revolutionary idea in finance?. Abacus, 49(S1), pp.7-23.

Brown, P. and Walter, T., 2013. The CAPM: theoretical validity, empirical intractability and practical applications. Abacus, 49(S1), pp.44-50.

Raei, R., Ahmadinia, H. and Hasbaei, A., 2011. A Study on Developing of Asset Pricing Models. Journal of Accounting and Finance, 1(1), p.1.

Magni, C.A., 2010. CAPM and capital budgeting: present/future, equilibrium/disequilibrium, decision/valuation. IUP Journal of Financial Economics, 8(1/2), p.7.

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