Capital Asset Pricing Model: Assignment with Course Text and ProQuest Article

Applying the Capital Asset Pricing Model (CAPM)Analyze the Capital Asset Pricing Model (CAPM). Using the course text and an article from
ProQuest as references, address the following: Explain how the CAPM assists in measuring both risk and return. Explain how the CAPM assists in calculating the weighted average costs of capital
(WACC) and its
components. Illustrate why some managers have difficulty applying the Capital Asset Pricing Model
(CAPM) in financial decision making. Identify the benefits and drawbacks of using the CAPM.Capital Asset Pricing Model (CAPM)The Capital Asset Pricing Model (CAPM) uses a mathematical model to create a percentage
representation of the risk for an investment (Byrd, Hickman, & McPherson, 2013). CAPM
builds on the premise that in general investors desire a risk free investment and as such they
demand higher rates of return based upon the perceived risk in an investment. Over time a
modification to the original CAPM formula was developed. The original formula or
computation worked from the premise of a risk free rate of return along with the addition of an
expected return on the market portfolio (Byrd et al., 2013).

The problem with this original
format is the fact that there is no risk free investment. While United States treasuries have
substituted for a risk free investment, they do carry risk. Therefore, a newer model of CAPM
was developed that uses a required rate of return in place of the risk free rate and then a market
risk premium. The benefit of this model is that analysis can be conducted based on how much
return is needed or expected from an investment. By conducting the calculation on an
investment using the published beta allows a comparison of risks between two investments.
While the results may not be perfect, they are correct from a comparison basis. Thus, as shown
in the text, JWN carries a calculated CAPM of 13.98% and PGE carries a CAPM of 6.25%
(Byrd et al., 2013).

These are great examples in that it is obvious that Nordstrom carries a higher
risk as an investment and therefore must pay higher rates for capital versus Pacific Gas and
Electric that may have a lower yield and lower cost of capital because it has a lower risk as an
investment.CAPM and the Weighted Average Cost of Capital (WACC)The WACC is a calculation showing the blended cost of all capital for a company across the
various capital creation sources (Byrd et al., 2013). For example if a company has bonds
outstanding, preferred stock, and common stock, each of those carries a different cost to the
company. Blending the costs allows the creation of a single WACC for the capital portfolio.
Thus, a company can determine what is the average cost of all sources of capital.