But estimating the cost of equity causes a lot of head scratching; often the result is subjective and therefore open to question as a reliable benchmark. This article describes a method for arriving at that figure, a method […]. This article describes a method for arriving at that figure, a method spawned in the rarefied atmosphere of financial theory. The capital asset pricing model CAPM is an idealized portrayal of how financial markets price securities and thereby determine expected returns on capital investments. The model provides a methodology for quantifying risk and translating that risk into estimates of expected return on equity. A principal advantage of CAPM is the objective nature of the estimated costs of equity that the model can yield.
EconPapers: The capital asset pricing model: a critical literature review
In finance , the capital asset pricing model CAPM is a model used to determine a theoretically appropriate required rate of return of an asset , to make decisions about adding assets to a well-diversified portfolio. CAPM assumes a particular form of utility functions in which only first and second moments matter, that is risk is measured by variance, for example a quadratic utility or alternatively asset returns whose probability distributions are completely described by the first two moments for example, the normal distribution and zero transaction costs necessary for diversification to get rid of all idiosyncratic risk. Under these conditions, CAPM shows that the cost of equity capital is determined only by beta. Sharpe , John Lintner a,b and Jan Mossin independently, building on the earlier work of Harry Markowitz on diversification and modern portfolio theory. Sharpe, Markowitz and Merton Miller jointly received the Nobel Memorial Prize in Economics for this contribution to the field of financial economics. This version was more robust against empirical testing and was influential in the widespread adoption of the CAPM.
A Critical Analysis of the Merits of the Capital Asset Pricing Model
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