CAPM & Portfolio Diversification

[Name of the Professor]

Abstract

The paper will discuss the three widely used models for equity valuation. All three will be elaborated and discussed in detail. Finally a model will be recommended based on the finding and suitability for SLP Company. CAPM Calculations will be conducted for three S&P stocks and the most suited security will be highlighted from an investor's perspective.

Table of Contents

ABSTRACT2

Introduction4

DISCUSSION4

Capital Asset Pricing Model4

CAPM Advantages5

CAPM Disadvantages6

DDM6

Problems with DDM6

Advantages of DDM6

Professional usage of DDM7

Arbitrage Pricing Theory8

CAPM & Arbitrage Pricing Theory8

Benefits of APT8

Drawbacks of APT8

CONCLUSION9

REFERENCES9

CAPM & Portfolio Diversification

Introduction

The purpose of this report is to determine the best model for determining the cost of equity. The models that will be analyzed include the Capital Asset Pricing Model, Dividend Discount Model and Arbitrage Pricing Theory. Detail analysis of each model will be given along with the benefits and drawbacks or each and then a decision as per which model should be used for SLP Company. CAPM is the best model for estimating the required rate of return for SLP Company. It has been tried and tested now for more than 40 years. It has been tested rigorously through empirical research and it has withstood the time. It considers the systemic risk for a diversified portfolio of securities and incorporates reality.

CAPM incorporates risk well by taking beta into account and gives investor two benefits in the form of time value of money and risk taking benefits. Other model such as dividend discount model has its shortcoming when it comes to companies that are not paying dividends; in that case the cost of equity goes negative which is hard to comprehend. The APT theory shouldn't be use as incorporating variables and finding its impact on the security is difficult to determine. Those using APT theory for finding cost of equity often gets to find that their risk estimates aren't up to the mark, which not makes it easier for them to determine whether an asset is under or overpriced.

Discussion

Capital Asset Pricing Model

CAPM is used widely for pricing risky securities. It is a model which is used in essence to determine the relationship between expected return and risk (Megginson, 1996). The CAPM is calculated using the below mentioned formula.

Ra= Rf + B (Rm - Rf)

Where:

Rf denotes risk free rate

B= Security's Beta

Rm= Expected market rate of return

The concept behind the formulation of CAPM is that investors should be rewarded in two ways. This includes the time value of money and secondly the risk being undertaken by the investor. Time value of money concept is demonstrated through the risk free rate. This will be the return which the investor will get for investing in the T Bills. This is usually risk free and guarantees a set return.

The other component of CAPM revolves around the concept of compensating investor's for taking on additional risk by investing in government securities. This is where the concept of Beta creeps in. This is a measure of the return that a security offers based on the security risk in comparison to ...