Capital Asset Pricing Model or CAPM

Answer

Capital Asset Pricing Model or CAPM

Capital Asset Pricing Model or CAPM theory is a portfolio theory that applies to capital markets. It establishes a theoretical linear relationship between an entity’s risks and the required rate of return for an investment. CAPM theory is based on the relationship that exists between an asset’s beta, equity risk premium and risk-free rate, mostly the Treasury bill rate (Fama, & French, 2004). It posits that risks can be classified into two major classes: systematic and unsystematic. Systematic risks refer to risks posed by general market conditions like recessions, interest rates or wars (Bodie, Kane, & Marcus, 2008).  Unsystematic risks are inherent to individual stocks. Portfolio theory posits that unsystematic risks can be minimized by diversification. CAPM factors systematic risks like beta that is not factored on other return models like dividend discount model (DDM). Market risks are critical variables as they are unforeseen and cannot be mitigated entirely.

In a multi-physician clinic there are weaknesses or strengths that can be experienced when CAPM is applied. The security market line or SML is basically a CAPM graphical representation. SML indicates the assets expected market returns at different systematic levels of risks. SML is also referred to as to characteristic line. Beta is represented by the X-axis while expected return is represented by the Y-axis or the risk free rate. The major disadvantage is that CAPM validity may not always be accurate in risk assessment. The risk free rate is drawn from the short-term government securities and the rates changes daily creating higher volatility rates. The yield cannot offer an effective rate for calculation for an entity like a clinic.

The other disadvantage is that the return can be calculated as the total sum of all capital gains plus the dividends earned from the market. When earnings are negative, the market returns also are negative and it affects the CAPM calculations. The major strength of CAPM is that it’s easy to use and it can be applied to derive a lot of possible outcomes to provide required rates of earnings. It is more useful to calculate required outcomes compared to DDM or Weighted Average Cost of Capital.

Debt and equity financing are both useful in a company. They form the basis of a company’s capital structure. However, too much debt can result in bankruptcy. Companies that do not have any debt in their portfolio are disadvantage. Debt capital allows entities to exploit more opportunities in the market and also to expand and grow (Ahmeti, 2015). The Modigliani and Miller’s (MM theory) Theorem of Capital Structure posits that the capital of an entity should have both equity and debt capital on order to exploit the market fully (Conn, n, d). Debt capital enables the company to gain taxes benefits as interest charges are exempted from taxes. Equity dividends are taxed compared to interest on debt capital. As much as equity capital is convenient it is expensive compared to debt capital (Conn, n, d). The best option is to have a 50:50 approach to debt and equity. The amount of equity a company has as part of capital should be equal to the debt capital that the company has.

Finally, debt and equity financing are both useful in a company. They form the basis of a company’s capital structure. However, too much debt can result in bankruptcy while equity capital only limits a company’s prospects of future growth.