The Relevance of the Capital Asset Pricing Model to a Company Seeking Essay

The Relevance of the Capital Asset Pricing Model to a Company Seeking to Evaluate its Cost of Capital - Essay Example The Capital Asset Pricing Model was devised by William Sharpe to calculate as well as explain â€Å"†¦the expected rate of return on an asset †¦ (that) †¦can be written as the risk-free rate of interest plus the asset’s normalized covariance with the market times the difference between markets expected the rate of return and the risk-free rate† (Milne, 1995, pp. 5-6). Under financial theory CAPM is a model that shows assets returns concerning principle in conjunction with econometric models (Milne, 1995, pp. 5-6), and is represented by the following formula (Burton, 1998, pp. 21-22): CAPM is calculated using the beta as it provides a measurement of a stock's volatility in terms of its movement comparison with the overall stock market (Burton, 1998, pp. 21-22). The above means that when a company’s share price moves in tandem with the market, with the beta of a stock is represented by 1 and a 15% movement indicated as 1.5 (Burton, 1998, pp. 21-22). Foster (1986, p. 337) provides a summary of the two assumptions present in the Capital Asset Pricing Model as represented by â€Å"1. Two statistics, the mean and variance, are sufficient to describe investor preferences over the distribution of future returns on a portfolio. 2. Investors prefer higher expected returns to lower expected returns for a given level of portfolio variance, and prefer lower variance to higher variance of portfolio returns for a given level of expected returns". Corporate finance managers utilize CAPM to determine the estimated discount rate that is connected to a project under consideration (Ferran, 1999, p. 12). In conjunction with the foregoing, CAPM is used as a means to measure the systematic risk present in equity investment projects (Megginson, 1997, Pp. 107-123).