What are the advantages and disadvantages of capital asset pricing model over portfolio theory?

Answer 1

ADVANTAGES OF THE CAPM

The CAPM has several advantages over other methods of calculating required return, explaining why it has remained popular for more than 40 years: It considers only systematic risk, reflecting a reality in which most investors have diversified portfolios from which unsystematic risk has been essentially eliminated.

It generates a theoretically-derived relationship between required return and systematic risk

which has been subject to frequent empirical research and testing.

It is generally seen as a much better method of calculating the cost of equity than the dividend growth model (DGM) in that it explicitly takes into account a company's level of systematic risk relative to the Stock Market as a whole.

DISADVANTAGES OF THE CAPM

The CAPM suffers from a number of disadvantages and limitations that should be noted in a balanced discussion of this important theoretical model.

Assigning values to CAPM variables

In order to use the CAPM, values need to be assigned to the risk-free rate of return, the return on the market, or the equity risk premium (ERP), and the equity beta. The yield on short-term Government debt, which is used as a substitute for the risk-free rate of return, is not fixed but changes on a daily basis according to economic circumstances. A short-term

average value can be used in order to smooth out this volatility.

Finding a value for the ERP is more difficult. The return on a stock market is the sum of the

average capital gain and the average dividend yield. In the short term, a stock market can provide a negative rather than a positive return if the effect of falling share prices outweighs the dividend yield. It is therefore usual to use a long-term average value for the ERP, taken from empirical research, but it has been found that the ERP is not stable over time. In the UK, an ERP value of between 2% and 5% is currently seen as reasonable. However, uncertainty about the exact ERP value introduces uncertainty into the calculated value for the required return. Beta values are now calculated and published regularly for all stock exchange-listed companies. The problem here is that uncertainty arises in the value of the expected return because the value of beta is not constant, but changes over time.

Using the CAPM in investment appraisal

Problems can arise when using the CAPM to calculate a project-specific discount rate. For

example, one common difficulty is finding suitable proxy betas, since proxy companies very rarely undertake only one business activity. The proxy beta for a proposed investment project must be disentangled from the company's equity beta. One way to do this is to treat the equity beta as an average of the betas of several different areas of proxy company activity, weighted by the relative share of the proxy company market value arising from each activity. However, information about relative shares of proxy company market value may be quite difficult to obtain.

A similar difficulty is that the ungearing of proxy company betas uses capital structure

information that may not be readily available. Some companies have complex capital structures with many different sources of finance. Other companies may have debt that is not traded, or use complex sources of finance such as convertible bonds. The simplifying assumption that the beta of debt is zero will also lead to inaccuracy in the calculated value of the project-specific discount rate.

One disadvantage in using the CAPM in investment appraisal is that the assumption of

a single-period time horizon is at odds with the multi-period nature of investment appraisal. While CAPM variables can be assumed constant in successive future periods, experience indicates that this is not true in reality.