The Capital Asset Pricing Model

The Capital Asset Pricing Model

The capital pricing model is a framework used for forecasting what returns on investment will be. It’s a theoretical framework; however, it could be explicitly utilized when an investor thinks about venturing into risky assets like volatile stocks (Barras, 2019). As the CFO, I see several strengths when examining the given CAPM. Although theoretical, this model offers extremely viable reasons for assessing the asset’s profitability. Also, it considers the risk encountered in venturing into such an asset, contrary to other models of calculating returns on investment. The security marketplace line demonstrates different investment levels and expected returns on each class, which allows investors to make optimal decisions.

The most excellent means of raising an organization’s capital is equity financing. This is because there is no loan to repay by using equity financing. The company is not subject to monthly loan repayment, which could be specifically vital if the company doesn’t at first earn a profit. This gives the company the autonomy to channel more funds into its expanding business (CFI, 2019). However, with debt financing, as the company obtains more and more loans, its chances of being unable to repay the debt increase. That’s because too much debt results in higher interest payments. When the company encounters a sluggish sales interlude and can’t generate adequate cash for paying its bondholders, it could enter into a default state.

The second advantage of using equity financing over debt financing is that a firm builds an in-house source of finance (retained earnings) through having on-board equity finance. The organization may own the company’s profits by utilizing capital to finance the augmented working capital and other funding needs. It eliminates other demanding means of raising money through other sources. Also, when additional money is used in ventures with a greater return than what’s on hand to equity investors, the organization successfully attains its owner’s wealth maximization objective (Hasan, 2018).

Third, with equity financing, there are no credit issues. When a company has debt issues, equity financing is the solitary option for money to fund growth. Even when debt financing is provided, the rate of interest could be extraordinarily high and payments extremely steep to be tolerable. The fourth advantage is that equity financing doesn’t take out funds from the company. Repaying debt loans removes funds from the company’s cash flow, decreasing the required money for financing growth. Finally, equity financing is more vital than debt financing because it aids long-term business planning.

Equity venture capitalists don’t anticipate an instant investment return (Woodruff, 2019). They have a longstanding view and experience the likelihood of losing their funds if the company fails.

References

Barras, L. (2019). A large-scale approach for evaluating asset pricing models. Journal of Financial Economics, 134(3), 549-569.

CFI. (2019). Debt vs. Equity Financing: Which is best? Retrieved on March 12, 2020, from https://corporatefinanceinstitute.com/resources/knowledge/finance/debt-vs-equity/

Hasan, Z. (2018). Debt, equity, universal banking, and Islamic finance: A note. Journal of Economic and Social Thought, 5(2), 179-183.

Woodruff, J. (2019). The Advantages and Disadvantages of Debt and Equity Financing. Chron.com.

 Retrieved on March 12, 2020, from https://smallbusiness.chron.com/advantages-disadvantages-debt-equity-financing-55504.html

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The capital asset pricing model, or CAPM, prices an individual security or portfolio. The general idea behind CAPM is that investors should be compensated in two ways, for the time value of their money and the risk incurred. The model helps investors calculate risks and what type of return they should expect. The risk-free rate represents the time money value, usually a 10-year government bond yield, compensating the investors for placing money in an investment over time. That is added to the other half of the formula, which represents risk. It calculates the compensation the investor needs for taking on additional risk. This is done by taking a Beta, which measures a stock’s volatility and multiplies it by its premium. The premium is calculated by subtracting the risk-free rate of return from the expected market return. For example, the expected return of a stock can be figured out in the following way using a model. If the risk-free rate is 3%, the Beta or risk measure of the stock is three, and the expected market return over the period is 11%. The store is expected to return 27%. In short, the investment should not be made if the expected return does not make the risk worth it.

The Capital Asset Pricing Model

Respond to the following questions:

• You are the chief financial officer (CFO) of a multi-physician clinic. Do you see weaknesses or strengths in the capital asset pricing model (CAPM)? Explain your response and support it with examples. Include consideration of the small market line (SML).
• Your chief executive officer (CEO) asks you to decide between debt and equity financing. Explain which the best option is. Discuss the factors that influence your decision.

As in all assignments, cite your sources in your work and provide references for the citations in APA format.

Your initial posting should be addressed at 300-500 words

and respond to 2 classmates’ responses to the discussion.