Question

1. Does the capital asset pricing model work for companies? 2. How can a company use it to their advantage? 3. In what ways will it work against a company?

Answer 1

1. Yes the capital pricing model works for companies. CAPM = Risk Free rate+ Beta *(Market Return - Risk free Rate).

2. A company can use it to calculate cost of equity through CAPM fairly easily .This can be used to calculate WACC. This can be used to discount projects and also can be used to calculate price of stock through Dividend Discount model where cost of equity can be calculated through CAPM model.

3. Since cost of Equity through CAPM model is calculated through historical data it fails to predict future cost of equity accurately and hence discount rates are calculated based on historical data and not on exact future discount rate. Since risk free rate is not fixed in real market but volatile and also no company can borrow at risk free rate CAPM is a disadvantage for calculating accurately cost of equity.