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- Date Submitted: 11/25/2010 02:41 AM
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Financial Analysis Tools |
A Managers Tool |
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Brian C. ArchuletaBUSN602American Military UniversityProfessor Theodore |
25 November 2010 |
|
Abstract
The goal of this assignment is to contrast the Capital Asset Pricing Model (CAPM) with the Discounted Cash Flows Method.
Keywords: CAPM, DCF, analysis, risk, investors, return
In order to contrast the Capital Asset Pricing Model (CAPM) and the Discount Cash Flow Model, we first need to understand what they are. Then, we will go into some advantages and disadvantages of both models. Finally, we will be able to contrast the two models and see which one might work best.
Teachmefinance.com says that Capital Asset Pricing Model (CAPM) looks at risk and rates of return and compares them to the overall stock market (McCraken, n.d.). Businessdictionary.com defines the Discount Cash Flow (DCF) as the value of the anticipated revenue stream from an investment as of today or any given date (BusinessDictionary.com, n.d.).
There are a few assumptions with CAPM: most investors want to avoid risk, and those that take risks want to be rewarded; investors are “price takers” who can’t influence the price of assets or markets; investors are not limited in their borrowing (McCraken, n.d.). There is a formula for the CAPM: Ks= Krf + B (Km-Krf)
Ks= rate of return
Krf= the risk free rate
B= the beta
Km= the expected rate of return on investment
As an example: Company A has a beta of 2, and an expected rate of return of 14% (you have to guess this number based on past performance and current conditions). Assuming a risk free rate is 5%, the result would be:
Ks= 5% + 2 (14% - 5%)
Ks= 5% + 2 (9%)
Ks= 5% + 18%
Ks= 23%
So, if you don’t think that Company A can produce 23% for a rate of return, the person might not want to invest in that company based on the beta.
The Discounted Cash Flow (DCF) method takes into account the present value of the dollar invested. It “discounts” the...
Financial Analysis Tools |
A Managers Tool |
|
Brian C. ArchuletaBUSN602American Military UniversityProfessor Theodore |
25 November 2010 |
|
Abstract
The goal of this assignment is to contrast the Capital Asset Pricing Model (CAPM) with the Discounted Cash Flows Method.
Keywords: CAPM, DCF, analysis, risk, investors, return
In order to contrast the Capital Asset Pricing Model (CAPM) and the Discount Cash Flow Model, we first need to understand what they are. Then, we will go into some advantages and disadvantages of both models. Finally, we will be able to contrast the two models and see which one might work best.
Teachmefinance.com says that Capital Asset Pricing Model (CAPM) looks at risk and rates of return and compares them to the overall stock market (McCraken, n.d.). Businessdictionary.com defines the Discount Cash Flow (DCF) as the value of the anticipated revenue stream from an investment as of today or any given date (BusinessDictionary.com, n.d.).
There are a few assumptions with CAPM: most investors want to avoid risk, and those that take risks want to be rewarded; investors are “price takers” who can’t influence the price of assets or markets; investors are not limited in their borrowing (McCraken, n.d.). There is a formula for the CAPM: Ks= Krf + B (Km-Krf)
Ks= rate of return
Krf= the risk free rate
B= the beta
Km= the expected rate of return on investment
As an example: Company A has a beta of 2, and an expected rate of return of 14% (you have to guess this number based on past performance and current conditions). Assuming a risk free rate is 5%, the result would be:
Ks= 5% + 2 (14% - 5%)
Ks= 5% + 2 (9%)
Ks= 5% + 18%
Ks= 23%
So, if you don’t think that Company A can produce 23% for a rate of return, the person might not want to invest in that company based on the beta.
The Discounted Cash Flow (DCF) method takes into account the present value of the dollar invested. It “discounts” the...