Capital Asset Pricing Model

The capital Asset Pricing Model is derived from a relatively simple concept, that the return on investment should be directly related to the amount of risk involved in the investment. This is a totally acceptable train of thought; the more risk one takes the greater the reward should be. We can extend this very readily to investing in shares, the return should be directly linked to the amount of risk involved. If we can accept this view then we can extend this to recognising that when undertaking investment appraisal we should use a cost of capital which reflects the risk of the particular investment and not the risk associated with the market as a whole or, even, the firm as a whole.

The Capital Asset Pricing Model (CAPM) was developed by Sharpe in 1964, initially to explain how share prices were arrived at in the market. The model is now used not only to value shares but also to find the rate of return required on any form of investment. We are not going to study the intricacies and faults of the model at this stage, it is not without its detractors, we are simply going to assess how it may be used to find the return required on capital investment.

Basically the model argues that the return required for investment is the equivalent of the risk-free rate plus a risk premium, ie that investors will expect a return that bears a direct relationship to the risk taken. This requires knowledge of three different issues, the risk-free rate in the market, the normal return on the market and the risk of the investment compared with the market as a whole. It is this last point that makes the model unique in that it requires an assessment of the performance of the investment, or an equivalent investment, against the performance of the market. Does the