Capital Asset Pricing

A. Compare and Contrast the Capital Asset Pricing Model and the Discounted Cash Flows Model.

Discounting future cash flows can be used to solve for the present value, but how can you determine what the interest rate or discount rate should be? The firm has to determine the cost of its funds, or cost of capital (Block, Hirt, 2005). The Capital Asset Pricing Model, known as CAPM, can be used to determine the required rate of return for common stock (Block, Hirt, 2005). Comparing and contrasting the differences between CAPM and discounted cash flows, will provide investors with information that can aid them in evaluating the financial performance of a firm.

The concept behind CAPM is investors need to be compensated in two ways: time value of money and risk. The time value of money is represented by the risk-free (rf) rate in the formula and compensates the investors for placing money in any investment over a period of time. The other half of the formula represents risk and calculates the amount of compensation the investor needs for taking on additional risk (Investopedia, 2007). Capital Asset Pricing Model (CAPM) can be described by the following formula:

Kϳ=Rϝ+в (Kⅿ-Rϝ)

Where

Kϳ= Required return on common stock

Rϝ= Risk-free rate of return; usually the current rate on Treasury bill securities

Ð'= Beta coefficient. The beta measures the historical volatility of an individual stock's return relative to a stock market index

Kⅿ= Return in the market as measured by an appropriate index (Block, Hirt, 2005).

For example, using the CAPM model and the following assumptions, we can compute the expected return of a stock: if the risk-free rate is 3%, the beta (risk measure) of the stock is 2 and the expected market return over the period is 10%, the stock is expected to return 17% (3%+2(10%-3%)) (Investopedia, 2007).

The discount rate determines the present value of future cash flows by