Valuation Techniques- CAPM

Question 1

What is the Capital Asset Pricing Model (CAPM)

Answer 1

Economic model that determines a measure of relationship between risk and expected return

Used in valuing various assets

CAPM Incorporates both:

• Time value of money
• Element of risk- “Beta”

Question 2

What is the CAPM formula?

Answer 2

RR = RFR + beta (ERR - RFR)

RR= Required rate of return

RFR= Risk free rate of return - Rate on US government bond

beta= measure of volatility of asset being measured

ERR= Expected rate of return - Benchmark rate for the class of asset being valued

Question 3

IF beta is greater than one, what does that mean?

Answer 3

Asset if more volatile

Less than one- Less volatile

Question 4

What are the CAPM assumptions and limitations? (KNOW)

Answer 4

There is an asset class and benchmark for the asset being valued

All investors have equal access to all investments of the class being valued and all use one-period time horizon

Asset risk is measured solely by the variance of the asset being valued from the asset class benchmark

No external costs involved- no commissions, taxes, etc.

No restrictions on borrowing or lending at the risk-free rate; all parties can do so

uses historical data, which may not be appropriate for computing future values or returns

Question 5

Use of CAPM include:

Answer 5

• Securities analysis
• Capital budgeting
• Company beta or industry beta used as surrogate for project bata
• Setting fair compensation for regulated monopolies