PAMANTASAN NG LUNGSOD NG MAYNILA

(University of the City of Manila)

General Luna, corner Muralla St. Intramuros, Manila,
1002 Metro Manila

College of Business Administration

MODULE 3: Theoretical Framework of Capital Markets

K. Capital Asset Pricing Model

Capital Markets
FIN 3207

Second Semester
A.Y 2024-2025

Submitted by:
Gaac, Fredzy Boy P.
Infante, Louisa Antoinette
Velasco, Cheska Marie R.

Submitted to:
Dr. Antonio E. Casurao, Sr., D.BA

February 2025

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 TABLE OF CONTENT

Abstract........................................................................................................ 3

Introduction................................................................................................... 4

Methodology................................................................................................. 7

Results and Discussions.............................................................................. 8

Conclusion................................................................................................... 21

References.................................................................................................. 23

Plagiarism Report........................................................................................ 26

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 ABSTRACT

The Capital Asset Pricing Model (CAPM) is a crucial financial instrument for
calculating risk-based investment returns. It aids investors in evaluating securities
by connecting expected returns to market risk through beta, expected market
return, and the risk-free rate. It is widely utilized in portfolio management and
strategic planning. Notwithstanding its benefits, CAPM has drawbacks, including
ignoring firm-specific risks and depending on assumptions about market efficiency.
A more thorough assessment and decision-making process for investments is
ensured when combining the CAPM with other financial models, even though it
offers a structured approach to risk-adjusted returns.

Keywords: Capital Asset, capital markets, capital asset pricing model, capital
theory, risk-free rate, expected return, expected market return, beta, risk, investing,
cost of equity, portfolio management

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 INTRODUCTION

The Capital Asset Pricing Model (CAPM) is one of the most commonly used
tools for estimating returns in the investment industry. CAPM has long played an
important role in portfolio management, investment analysis, and corporate
finance. Its simplicity, with a focus on risk and return, makes it a useful tool for
investors, financial analysts, and corporate decision-makers. CAPM insights are
critical for making a variety of financial decisions, including capital budgeting, asset
allocation, and security valuation.

Sharpe's 1964 introduction of the widely recognized Capital Asset Pricing

Model (CAPM) was a significant step forward in establishing the general
equilibrium conditions that govern risk and return in financial markets. This
theoretical framework was based on earlier work by Markowitz (1959), whose
Nobel Prize-winning research on diversification resulted in the mean-variance
efficient investment parabola. This model was developed in the 1960s by William
Sharpe, John Lintner, and Jack Treynor, CAPM provides a framework for
understanding the relationship between an asset's expected return and its
systematic risk (Brooks, 2023).

While the CAPM is recognized for its significant contribution to the

investment landscape, due to its lack of empirical backing, the Capital Asset
Pricing Model (CAPM) has drawn a lot of criticism since its inception. In the 1990s,
Professors Eugene Fama and Kenneth French came to the conclusion that the
CAPM did not match real-world data after performing a number of tests on the
relationship between stock returns and beta (β) using stock market indexes to
approximate the theoretical market portfolio (1992, 1993, 1995, 1996). They
discovered that, for over 25 years, there was no correlation between higher (or
lower) betas and higher (or lower) average returns for U.S. stocks. Due to this
empirical failure, Fama and French deemed CAPM to be outdated and suggested
three, five, and even six factor alternative models. Zero-investment elements like
size, book-to-market equity (value), profitability, capital investment, and
momentum were included in these models. Building long/short portfolios is a

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component of each factor (for instance, for the size factor, long small stocks and
short large stocks) (Erhardt, 2011).

According to Erhardt & Brigham (2011), these zero-investment factors are

empirically derived based on their relevance in asset pricing tests using U.S. stock
returns, rather than being linked to the theoretical framework of general equilibrium
pricing that underpins Sharpe's CAPM, despite the fact that they have gained
popularity among academics and practitioners and have demonstrated some
empirical significance. They are frequently called ad hoc models as a result. There
are now hundreds of multifactor models in the finance literature as a result of
researchers adopting Fama and French's long/short factor construction approach.
These competing multifactor models now vie for relevance in an ongoing process
of empirical selection, evolving within the realm of asset pricing theory.

Investors and financial managers may base their decisions on erroneous or

insufficient information if the limitations of the CAPM are not completely recognized
or addressed. For instance, there may be a large mispricing of assets if the CAPM
is used to calculate an asset's expected return without taking non-systematic risks
or market inefficiencies into account. Suboptimal investment choices, such as
overpriced or underpriced stocks, could result from this mispricing, which could
lower profitability or increase risk exposure. Additionally, using CAPM to decide
asset allocation in portfolio management may lead to portfolios that underrepresent
the actual risks involved, which would impact the stability and overall performance
of investments. When the CAPM is misused, investors may believe they are being
fairly compensated for the risks they are taking, but in reality, the model may be
ignoring some risk factors. This could give investors a false sense of security. Such
poor decisions could have an effect on institutional investors, bigger financial
markets, and even entire nations' economies in addition to individual investors
(Kenton, 2024).

In light of the introduction of CAPM and its function alongside its difficulties,
it is crucial to assess the assumptions and constraints of CAPM critically while
investigating the nature of CAPM, its purposes, and its application in investment

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portfolios. The purpose of this study is to examine the complexity of CAPM by
addressing it in determining its roots and examining its underlying assumptions
and how market imperfections affect the model's performance.

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 METHODOLOGY

This research employs a qualitative approach through an extensive review

of academic literature, scholarly articles, and credible financial sources to examine
the Capital Asset Pricing Model (CAPM). The study aims to understand CAPM's
function, components, applications, and limitations in evaluating the relationship
between risk and return in the financial market. This research is the outcome of a
comprehensive review of academic literature, the ideas and views were influenced
by several thorough references and articles by competent authors, credible
website references written by professional writers. Through this process, the
researcher gathered valuable information to create a detailed report which
enhances the understanding of CAPM and its implication for investment decision
making.

This study aims to answer the following guide questions:

1. What is the Capital Asset Pricing Model (CAPM), and how does it help in
evaluating the relationship between risk and return in the capital market?
2. What are the key components of the Capital Asset Pricing Model (CAPM),
and how do they contribute to determining the expected return on
investment?
3. How can the CAPM formula be applied to calculate the expected return on
an investment, and what are the steps involved in performing such a
calculation?
4. What are the major assumptions behind CAPM, and what are the criticisms
and limitations of the model in the context of real-world financial analysis?
5. How is the Capital Asset Pricing Model (CAPM) applied in real-world
scenarios, especially in determining the cost of equity and making informed
investment decisions?

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 RESULTS AND DISCUSSIONS

The Capital Asset Pricing Model (CAPM) is one of the most commonly
utilized models for estimating investment returns in the financial industry. In the
book, Chandra (2012) stated that the Capital Asset Pricing Model (CAPM) predicts
the relationship between an asset's risk and its expected return. This relationship
is valuable in two key ways. First, it provides a benchmark for evaluating different
investments. For instance, when analyzing security, we can compare its expected
return with the fair return indicated by the CAPM. Second, it allows us to estimate
the return on an asset that has not yet been traded in the market, aiding in more
informed decision-making. CAPM, in essence, is a helpful model for investors to
gauge the level of risks and returns associated with their investment portfolio.

3.K.1. Definition and function of Capital Asset Pricing Model

According to Kenton (2024), the Capital Asset Pricing Model (CAPM) is

defined as the financial framework used to estimate the expected return on an
investment by considering its level of risk in relation to overall market risks. This
model is widely used by investors seeking to know the cost of certain investments
such as equity or stocks.

In the 1960s, John Linter and William F. Sharpe created the Capital Asset
Pricing Model (CAPM). This model, which illustrates the connection between
inevitable risk and anticipated return from security, is helpful for calculating the
firm's equity capital cost. It focuses on systematic risk which refers to uncertainties
that investors cannot eliminate such as fluctuations in interest rates, exchange
rates and inflation.Since market prices generally move together, even companies
with weaker performance may see price increases when the overall market is
strong. To compensate for this risk, investors receive risk premiums with higher
premiums required for riskier investments (Sana 2017; Russo, 2024).

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 Furthermore, as Girarde (2023) points out, CAPM is widely adopted in the
banking industry and is vital in directing strategic decision-making processes.
Investment bankers and investors frequently use this model to assess the risk and
possible returns of individual investments and estimate how diversified investment
portfolios would perform over time. Financial professionals who incorporate CAPM
into their analytical instrument receive important insights into asset price dynamics
and market risks, allowing them to make informed decisions consistent with their
investment objectives. As a result, CAPM is a core technique that helps evaluate
individual investments and informs broader portfolio management strategies,
providing stakeholders with the tools they need to navigate financial markets
confidently and clearly.

3.K.2. Components of CAPM

The Capital Asset Pricing Model (CAPM) comprises several essential

components that can help with estimating the anticipated return on an investment
in relation to its degree of risk. This includes risk-free rate of return, expected return
of investment, beta, and expected market return. Each component plays an
essential role in determining the total necessary return on an asset, which provides
investors with important information as they evaluate investment prospects in light
of market risk and general economic conditions (Team, 2023).

3.K.2.1 Risk-free rate of Return

As stated by Vipond (2024), the Risk-free rate of Return represents the

return an investor can anticipate from an investment that has no associated risk.
In practical terms, it is often approximated by the return on a 10-year government
treasury note which is considered as the safest investment option available.
Despite being a theoretical concept, the risk-free rate is typically correlated to
government-issued securities such as Treasury bonds because the risk of a
government defaulting on its debt is considered extremely low.

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 The equity fee's foundation lies in the risk-free rate, typically determined by
government bonds. This rate represents the minimum return investors expect for
a risk-free investment and serves as a reference point for assessing additional risk
in the stock market. A higher equity risk premium suggests greater potential returns
from stocks compared to risk-free assets, incentivizing investors to take on risk
within their tolerance levels. Calculating the equity risk premium helps investors
gauge the potential additional return compared to the risk-free rate. In the CAPM
approach for calculating the cost of equity, the risk-free rate is the return on risk-
free investments like Treasuries (Kenton, 2024; Harshinidevi and
Harshinidevi,2024).

3.K.2.2 Expected return of investment

The expected return of investment represents the anticipated profit or loss

from an investment which is calculated based on historical rates of return. While
the expected return provides a reasonable estimation, it is important to note that it
is not a guaranteed outcome. This estimation is often seen as long-term average
of past returns which provides investors with an idea of what they might expect in
the future under normal circumstances. The concept of expected return is central
to various financial models including Modern Portfolio Theory (MPT) and the Black-
Scholes option pricing model which are both instrumental in evaluating investment
decisions (Chen, 2024).

3.K.2.3 Beta

Based on the website WallStreetPrep (2024), in corporate finance, beta is

a metric used to assess the systematic risk of an asset which reflects how the
asset’s returns are correlated with the overall market’s returns. This type of risk is
also known as non-diversifiable risk which cannot be mitigated through
diversification.

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 Brooks defined nondiversifiable, or systematic risk inherent risk in the
market that cannot be eliminated through diversification. This type of risk is linked
to broader economic and political factors that influence the overall movement of
the economy. The extent to which an individual asset or portfolio moves in relation
to the market is quantified using beta. Beta is a statistical measure that assesses
the volatility of a security relative to the overall market, indicating the degree to
which a security's returns fluctuate in response to market movements. Beta is
determined by calculating the covariance between expected returns on the asset
and the market, divided by the variance of expected returns on the market.

The relationship between beta (β) and the expected market sensitivity is as follows:

•β = 0: No Market Sensitivity
•β < 1: Low Market Sensitivity
•β = 1: Same as Market (Neutral)
•β > 1: High Market Sensitivity
•β < 0: Negative Market Sensitivity

Beta, in essence, ascertains a stock's volatility concerning the market. A

company's beta significantly influences its equity cost, with a higher beta
correlating to elevated expenditure due to the amplified risk. Moreover, beta's
sensitivity to the number of years of data utilized is notable. Insufficient years lead
to limited observations, rendering the regression statistically insignificant, while
excessive years may enhance statistical significance but risk a deviation from the
"true" beta over the sample period. As a practical approach, it is common to employ
either 3 to 5 years of monthly returns or 1 to 2 years of weekly returns for beta
calculation (Harshinidevi, & Harshinidevi, 2024)

3.K.2.4 Expected market return

The expected market return refers to the anticipated percentage gain or loss
from a broad market index over a specific period. It serves as a key component in

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financial models like the CAPM which help investors assess potential return based
on risk exposure. In CAPM, it represents the overall performance of the stock
market and is often estimated using historical data indices like the S&P 500. This
return includes both capital appreciation and dividend income. Investors use it as
a benchmark to compare individual investment returns and assess whether the
additional risk taken is justified (Lazaroff & Lazaroff, 2024).

3.K.3. Criticisms and Limitations of using CAPM

As outlined by the website FasterCapital (2025), the CAPM is widely

recognized in investment analysis for assessing risk and determining asset prices.
It operates under the assumption that investors make rational decisions, prefer
lower risk and maintain a diversified portfolio. Additionally, the model assumes the
absence of transaction costs, taxes and market inefficiencies. Despite its
significance, CAPM has faced several criticisms and limitations over time.

3.K.3.1 Assumptions

Developed by William F. Sharpe and John Lintner in the 1960s, the Capital
Asset Pricing Model (CAPM) serves as a valuable tool for assessing a firm's cost
of Equity Capital, illustrating the link between inherent risk and anticipated returns
from security. This model operates under several key assumptions: highly efficient
capital markets, no individual investor possessing market influence, uniform
expectations regarding risk and return among investors, minimal investment
constraints, and the presence of two investment options, risk-free securities, and
market portfolios comprised of common stocks (Sana et. al., 2017).

Several books and articles emphasized that the Capital Asset Pricing Model
(CAPM) is built upon several key assumptions that help simplify the analysis of
investment returns. These assumptions include the notion that investors are

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rational and make decisions based on expected returns and risks (Reilly et al,
2020; Indeed Editorial team, 2024; Kenton, 2024).

The following assumptions associated with the CAPM are as follows:

1. Investors are risk-averse

The CAPM assumes that investors exhibit a preference for avoiding risk.
Investors are expected to have the choice to either accept or avoid risk. The model
suggests that individuals will make decisions by diversifying their portfolios to
spread the risk. This approach involves selecting various assets that carry different
levels of risk, allowing for an overall more balanced portfolio in response to
fluctuating conditions (Indeed Editorial Team, 2024).

2. Investors have the freedom to maximise the utility of terminal wealth

According to the CAPM, investors have the ability to prioritize the
maximization of their terminal wealth. The model acknowledges that individuals
may have different preferences and will seek to optimize their wealth in a way that
best suits their needs. The focus here is on increasing wealth, but the marginal
benefit of additional wealth diminishes, as the ultimate goal is to achieve a desired
level of terminal wealth (Indeed Editorial Team, 2024).

3. Investors have the freedom to choose based on risk and return

The CAPM assumes that investors can make investment decisions based
on the comparison between the risks and expected returns of different assets. The
model emphasizes that unsystematic risks, which are diversifiable, should be
eliminated, leaving only systematic risks to influence investment choices. To
assess these risks, investors may use tools such as Beta or variance, which help
to quantity both the risk and the expected reward (Indeed Editorial Team, 2024).

Reilly et. al (2020) emphasized this assumption stating that any amount of
money can be borrowed or lent by investors at the risk-free return (RFR).

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(Obviously, purchasing risk-free securities, like government T-bills, always makes
it possible to lend money at the nominal risk-free rate; however, we will see that
assuming a higher borrowing rate does not change the general results.)

4. Provides a portfolio to compare similar expectations and returns

The CAPM provides a framework for constructing portfolios before any
actual investment decisions are made. Investors may have varying expectations,
which can lead to differences in how they forecast returns. The model takes into
account that individual preferences can cause differing valuations of the same
assets, leading to different investment choices and return projections (Kenton,
2024; Indeed Editorial Team, 2024).

5. Similarity to time horizon

The model assumes that many investors have similar investment time
horizons. Investors may purchase and hold assets in their portfolios until a
designated point in the future, at which they plan to sell. This common time frame
allows investors to form portfolios with the aim of achieving a particular financial
target, and the CAPM can be used to create a one-period model that reflects this
shared time horizon (Indeed Editorial Team, 2024).

According to Reilly et. al. (2020), This assumption tells that all investors
have the same one-period time horizon, such as one month or one year. The model
will be developed for a single hypothetical period, and its results may be influenced
by a different assumption, as it requires investors to derive risk measures and risk-
free assets that correspond to their investment horizons.

6. Investors have free access to information

Under the assumptions of the CAPM, it is assumed that investors have full
access to relevant information prior to making investment decisions. With this
information at their disposal, investors are better equipped to make informed
choices, thereby improving the efficiency of the market. The ability to access

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comprehensive data helps investors assess risks and rewards more effectively,
contributing to sound investment strategies (Indeed Editorial Team, 2024).

7. Free from taxes and transaction costs

According to Reilly, et. al (2020), In many cases, it is a reasonable
assumption that there are no taxes or transaction costs associated with the
purchase or sale of assets. The transaction costs for the majority of financial
institutions are less than 1% on the majority of financial instruments, and neither
charitable organizations nor pension funds are required to pay taxes. Again,
relaxing this assumption does not change the basic result.

A key assumption in the CAPM is the absence of taxes and transaction

costs, allowing investors to engage in risk-free investments or portfolios that
involve short-selling. This eliminates additional financial burdens that could affect
the overall returns on investments. The model assumes that there are no extra
costs beyond the basic market transactions, and this is represented in the form of
a capital market line (Indeed Editorial Team, 2024).

3.K.3.2 Criticisms and Limitations

There is more to the Capital Asset Pricing Model than the theoretical
concepts found in textbooks. Analysts, investors, and corporations use it
extensively because of its high level of intuitive appeal. However, its validity has
been called into question by several recent studies.

Assumptions

The formula only works if we believe that rational actors dominate the
market and make decisions based only on investment returns. However, this is
only sometimes the case. Furthermore, the model implies that all market
participants act on the same information. The necessary data is not evenly

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distributed to the public; thus, some actors may judge based on information others
do not have (Girardin, 2023).

Limitations

According to Yogi (2023), the Capital Asset Pricing Model (CAPM) has a
number of limitations, including the need for consensus on the rate of return and
the selection of one. In addition, the market return uses historical data in a similar
manner and anticipates positive returns. This also holds true for the beta, which is
only available for publicly traded companies. Furthermore, the beta only considers
systematic risk; it does not account for the risk that companies face in various
markets. Among other assumptions, it must be assumed that investors will have
unrestricted access to the risk-free rate of borrowing.

Calculation of Beta Coefficient

According to Girardin (2023), Another major issue with the capital asset
pricing model is its reliance on beta as a critical component of the methods. Beta
means that positive or negative changes in a stock's price imply volatility and
market sensitivity. However, a stock's price might fluctuate for causes other than
the market. Stock prices may rise or decrease for intentional causes rather than
just due to volatility.

In this regard, beta ignores the fact that price fluctuations in either direction
carry equal risk. Furthermore, focusing on a specific time frame for risk
assessment ignores the fact that returns and risk do not spread equally over time.
Beta coefficients for investments fluctuate over time. Beta coefficient values for
publicly traded companies are calculated on a regular basis and made available to
investors, but they do not remain constant. This adds uncertainty to the process of
calculating the rate of return on an investment. (Cautero, 2023).

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 Several studies have also revealed no historical correlation between the
returns of stocks and their market betas, supporting a long-held belief among some
academics and stock market analysts. Researchers and practitioners are creating
models with more explanatory variables than just beta as an alternative to the
conventional CAPM. These multi-factor models are an appealing extension of the
classic CAPM model's finding that asset pricing is driven by market risk, or risk that
cannot be mitigated by diversification. While the CAPM only measures risk in
relation to market portfolio returns, the multi-variable models assume that risk is
caused by a variety of factors, such as firm size, market/book ratios, liquidity
measures, and the like. Although the multi-variable models are a potentially
significant advancement in finance theory, their practical application is not without
flaws. As a result, the basic CAPM is still the most widely used method for thinking
about required rates of return on stocks (Erhardt & Brigham, 2011; Chen et. al,
2022).

Constant Risk-free Rate

The idea of a risk-free asset is a key component that enabled portfolio

theory to evolve into capital market theory. Many writers examined the
ramifications of presuming the existence of a risk-free asset, or an asset with zero
variance, after the creation of the Markowitz portfolio model. We will demonstrate
that such an asset would yield the risk-free return (RFR) and have no correlation
with any other risky assets (Brooks, 2024).

However, the assumption that CAPM is always a constant risk-free rate is

not necessarily true all the time. An increase of as low as 1% in treasury bond rates
could greatly affect the investments. A stock index such as the S&P 500, on the
other hand, only offers a theoretical value because its performance may vary over
time (Cautero, 2023).

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Relies on Historical Data

This is a problem with many financial models and is almost impossible to

prevent. Furthermore, in the capital asset pricing model, a stock's previous price
variations need to be revised to assess the entire investment risk. To really
appreciate the risk of an investment, other factors must be examined, such as
economic conditions, the stock industry, and competitors, as well as the company's
internal and external actions (Girardin, 2023).

3.K.4. Formula and Calculation of CAPM

The Capital Asset Pricing Model (CAPM) is primarily used to determine the
cost of equity, as it focuses on the relationship between systematic risk and
expected returns for equity investments. The calculation for CAPM is generally
utilized in the business landscape as it is crucial in the calculation of the Weighted
Average Cost of Capital that is also used in determining the cost of equity. Below
is the formula for calculating the CAPM:

E(Ri) = Rf + βi* [E(Rm) – Rf]

Required return on stock = risk-free rate + beta of stock x (expected market

return - risk-free rate)
Where:
● E(Ri) = Expected return on asset i
● Rf = Risk-free rate of return
● βi = Beta of asset i
● E(Rm) = Expected market return

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Caselet #1

Anna is an investor evaluating a stock, Andreison Corp, to determine

whether it is a good investment. She decides to use the Capital Asset Pricing
Model (CAPM) to estimate the expected return on Andreison Corp’s stock and
compare it to other investment opportunities.

Given Data:
(Rf): 4% or 0.04
(βi): 1.5 (Indicating the stock is 50% more volatile than the market)
(E(Rm)): 10% or 0.10 (Based on historical market performance)

E(Ri) = Rf + βi* [E(Rm) – Rf]

E(Ri)= 0.04 + 1.5 ( 0.10 - 0.04 )
E(Ri)= 0.04 + 1.5 ( 0.06 )
E(Ri)= 0.04 + 0.09
E(Ri)= 0.13 or 13%

Using CAPM, Anna calculates that the expected return on Andreison Corp’s
stock is 13%. If Andreison Corp’s stock is offering a return lower than this, it may
not be an attractive investment given the risk level. Conversely, if its actual return
is higher, it may be a good opportunity.

Caselet #2

Mark, a financial analyst at RuPaul’s Drag Race Manufacturing Co, needs

to estimate the company’s cost of equity to help determine the appropriate discount
rate for evaluating new investment projects. He decides to use the Capital Asset
Pricing Model (CAPM) to calculate the cost of equity.

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Given Data:

(Rf): 5% or 0.05

(βi): 1.2

(E(Rm)): 12% or 0.12

E(Ri) = Rf + βi* [E(Rm) – Rf]

E(Ri) = 0.05 + 1.2 (0.12 - 0.05)
E(Ri) = 0.05 + 1.2 (0.07)
E(Ri) = 0.05 + 0.084
E(Ri) = 0.134 or 13.4%

The calculated cost of equity for ABC Manufacturing is 13.4%, meaning that
investors expect at least this return to compensate for the stock’s level of risk. This
rate will be used in capital budgeting to assess whether potential investments can
generate returns higher than 13.4%, ensuring that they add value to the company.

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 CONCLUSION

The Capital Asset Pricing Model (CAPM) remains to be one of the most
influential and widely used financial models for forecasting investment returns and
risk. CAPM is an important tool for investors, financial analysts, and banking
professionals to use when evaluating securities and making informed investment
decisions because it defines the relationship between an asset's expected return
and its level of risk. It establishes a standardized benchmark for comparing
investment opportunities, ensuring that potential returns match the associated
risks. Furthermore, CAPM enables investors to forecast returns on assets that
have not yet been actively traded in the market, making it an important model for
strategic financial planning and portfolio management.

The model's broad use, especially in the banking industry, emphasizes how
crucial it is for directing investment strategies and evaluating the long-term
performance of diversified portfolios. Financial experts use CAPM to assess
market risks, analyze asset price dynamics, and match investment decisions with
long-term financial goals. By combining important elements like beta, expected
market return, and risk-free rate, CAPM assists investors in figuring out the right
return needed to offset the degree of risk associated with an asset. More accurate
financial decision-making is made possible by this analytical method, which lowers
uncertainty in investment choices.

While the CAPM offers significant aid to investors, it is also important to take
into account that CAPM has a number of limitations despite its effectiveness. A
number of theoretical presumptions form the basis of the model, including the
existence of efficient capital markets, consistent investor expectations, and
unfettered access to risk-free borrowing. These presumptions might not always
accurately represent actual circumstances, which could affect how accurate
CAPM's forecasts are. Furthermore, there are issues with using beta as a gauge
of systematic risk and estimating market returns based solely on historical data.
Specifically, beta only takes into account market-related risks; firm-specific risks
that could impact an asset's performance are not taken into account. Because of

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this restriction, CAPM is less useful for evaluating investments in businesses that
are involved in highly specialized or volatile industries.

In summary, while CAPM provides a structured and widely accepted

method for evaluating risk-adjusted returns, investors should be aware of its
constraints. Given its reliance on specific assumptions and historical data, CAPM
is best used in conjunction with other financial models to achieve a more
comprehensive assessment of investment opportunities. By integrating CAPM with
additional risk analysis techniques, investors can develop a more robust
investment strategy that considers both systematic and unsystematic risks,
ultimately leading to better-informed financial decisions.

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Chen, J. (2024, September 25). Expected return: What it is and how it works.
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applications). Indeed Career Guide. https://uk.indeed.com/career-
advice/career-development/what-is-capm-model

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Kenton, W. (2024, July 1). Capital Asset Pricing Model (CAPM): Definition,
formula, and assumptions. Investopedia.
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Kenton, W. (2024, June 8). Cost of Equity: Definition, Formula, and example.
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Expectations with Investments. Plancorp, LLC.
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Yogi A. (2023). What are the limitations of using CAPM to calculate cost of equity?.
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BOOK SOURCES

Brooks, R. (2023). Financial Management Core Concepts Fourth Edition Global

Edition. Pearson Edcuation Ltd.

Chandra, P. (2012). Investment Analysis and Portfolio Management Fourth

edition. Tata McGraw Hill Education.

Ehrhardt, M., & Brigham, E. (2011). Financial Management: Theory and Practice
13th edition. South-Western Cengage Learning

Reilly, FK., Brown, K.C., Lamba, A.S., Gunasingham, B., & Elston, F. (2020).
Investment Analysis and Portfolio Management Asia-Pacific Edition.
Cengage Learning Australia Pty Limited.

Sana, A., Biswas, B., Sarkar, S. Das, S. (2017). Financial Management. McGraw
Hill Education

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PLAGIARISM REPORT

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