29 Sep 2022


The Capital Asset Pricing Model: Theory and Evidence

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Academic level: College

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The beta of the company measures the volatility and systematic risk compared to the market. Thus, capital assets pricing model will use the beta and expected market returns to calculate the expected return of the company. According to the Yahoo Finance, the beta of Merck & CO INC is 0.94 within one year (52 Weeks). When the company beta is equal to 1, it shows that the security prices will shift in the direction of the market hence less volatile. In cases, where the company beta is greater than one it is a sign that the price of the company’s security prices is more volatile compared to the market.

In the case of Merck & CO INC, the beta is less than one which indicates it is less risky compared to the prices of the market security. However, high risk is associated with high earnings of the company. Thus, most of the investors will prefer projects or securities with higher risks or since they promise higher returns. In a nut cell, the beta of Merck & CO INC expresses the tradeoff of the company between activities intended to maximize returns while minimizing risks. Similarly, the beta coefficient of 0.94 is less volatile compared to the market hence the company is expected to earn lower returns out of their risk and return tradeoff. Using CAPM, the cost of equity will be as follows.

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Ke = R F + β (Rm - R F )

Where Ke is the cost equity, R F is the risk-free rate, β is the beta coefficient, and Rm is the expected return in the market.

Ke = 4.5 + 0.94 (6.5) = 10.61%

The cost of equity is considered to be expected return from the company in the perspective of the investors at its current market prices. Thus, it is the company’s required rate of return by the investors. Consider investing a portfolio in two companies such as Pfizer and Amgen who have a beta of 1.4 and 1.76. The beta of the portfolio would be equal to β = (0.94*1/3) + (1.4*1/3) + (1.76*1/3) = 1.37. The expected return would be ER =4.5 + 1.37(6.5) = 13.38%. After diversification, the risk reduces compared to individual investment and the returns increases. However, the risk can be diversified further by increase the number of assets in the portfolio.

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StudyBounty. (2023, September 15). The Capital Asset Pricing Model: Theory and Evidence.


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