Does the Capital Asset Pricing
Model Work?
by David W. Mullins, Jr.

An important task of the corporate financial manager is measurement of the company’s
cost of equity capital. But estimating the cost of equity causes a lot of head scratching;
often the result is subjective and therefore open to question as a reliable benchmark. This
article describes a method for arriving at that figure, a method spawned in the rarefied
atmosphere of financial theory. The capital asset pricing model (CAPM) is an idealized
portrayal of how financial markets price securities and thereby determine expected returns
on capital investments. The model provides a methodology for quantifying risk and
translating that risk into estimates of expected return on equity.

A principal advantage of CAPM is the objective nature of the estimated costs of equity that
the model can yield. CAPM cannot be used in isolation because it necessarily simplifies the
world of financial markets. But financial managers can use it to supplement other
techniques and their own judgment in their attempts to develop realistic and useful cost of
equity calculations.


lthough its application continues to spark vigorous debate, modern financial
theory is now applied as a matter of course to investment management. And
increasingly, problems in corporate finance are also benefiting from the same

techniques. The response promises to be no less heated. CAPM, the capital asset pricing

model, embodies the theory. For financial executives, the proliferation of CAPM
applications raises these questions: What is CAPM? How can they use the model? Most
important, does it work?

CAPM, a theoretical representation of the behavior of financial markets, can be employed
in estimating a company’s cost of equity capital. Despite limitations, the model can be a
useful addition to the financial manager’s analytical tool kit.

The burgeoning work...

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