University of Phoenix
Long Term Financing
Learning Team A
August 8, 2008
The capital asset pricing model (CAPM) is used in finance to determine the appropriate required rate of return on common stock. It describes the relationship between risk and expected return. This model accounts for two methods of compensating investors (1) time value of money and (2) risk (Investopedia.com, 2008). There are two types of risk associated with this model: systematic and unsystematic risks. The systematic risk, or “undiversifiable” risk, refers to risks that are common to all securities. The unsystematic risk, or “diversifiable” risk, refers to risks that are associated with individual assets. The CAPM model does have some limitations or short comings. For example, it assumes that all investors will prefer higher returns and lower risk; it does not account for certain investors like stock traders and casino gamblers.
The discounted cash flow model (DCF) is a valuation method used to evaluate the appeal of an investment opportunity (Investopedia.com, 2008). The DCF calculates present value using projections of discounted free cash flows. To determine whether or not an investment is a good opportunity, the DCF should be higher than the current cost of the investment. The purpose of the DCF model is to estimate the money received from an investment and to adjust for the time value of money. The DCF also has some limitations or short comings. One example of a disadvantage of the DCF model is the assumption that future free cash flow streams are all highly predictable and deterministic. This assumption makes it difficult to estimate future cash flows as they are usually stochastic and risky in nature (Mun, 2003).
The capital asset pricing model can be compared and contrasted against the discount cash flow model by evaluating some of...