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An estimation of the CAPM and the security market line (purple) for the Dow Jones Industrial Average over 3 years for monthly data.. In finance, the capital asset pricing model (CAPM) is a model used to determine a theoretically appropriate required rate of return of an asset, to make decisions about adding assets to a well-diversified portfolio.
In theory, an "unbiased" value is the probability-weighted average of the various scenarios (discounted using a WACC appropriate to each); see First Chicago Method and expected commercial value. Note that in practice the required probability factors are usually too uncertain to do this. [12]
The weighted cost of capital (WACC) is used in finance to measure a firm's cost of capital. WACC is not dictated by management. Rather, it represents the minimum return that a company must earn on an existing asset base to satisfy its creditors, owners, and other providers of capital, or they will invest elsewhere. [4]
Mean-variance efficiency of the market portfolio is equivalent to the CAPM equation holding. This statement is a mathematical fact, requiring no model assumptions. Given a proxy for the market portfolio, testing the CAPM equation is equivalent to testing mean-variance efficiency of the portfolio.
Since return on invested capital is said to measure the ability of a firm to generate a return on its capital, and since WACC is said to measure the minimum expected return demanded by the firm's capital providers, the difference between ROIC and WACC is sometimes referred to as a firm's "excess return", or "economic profit".
Financial modeling is the task of building an abstract representation (a model) of a real world financial situation. [1] This is a mathematical model designed to represent (a simplified version of) the performance of a financial asset or portfolio of a business, project, or any other investment.
Proposed by economist Stephen Ross in 1976, [1] it is widely believed to be an improved alternative to its predecessor, the capital asset pricing model (CAPM). [2] APT is founded upon the law of one price, which suggests that within an equilibrium market, rational investors will implement arbitrage such that the equilibrium price is eventually ...
The CAPM is a model that derives the theoretical required expected return (i.e., discount rate) for an asset in a market, given the risk-free rate available to investors and the risk of the market as a whole. The CAPM is usually expressed: