4.
5 A MODEL OF COST OF CAPITAL
A Capital Asset Pricing Model
(CAPM)
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
• Relationship between the
2 Three main uses for CAPM efficient market price of security,
risk, and the expected rate of
return
3 CAPM Model
• Sharpe-Lintner capital asset
pricing model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM)
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing Assumptions;
Model(CAPM)
1.All investors are rational risk averse investor.
2.All investors aim to maximize economic
2 Three main uses for CAPM utilities.
3.All investors are able to lend and borrow at
risk-free rate.
3 CAPM Model 4.Perfect Competitive
- no taxes
- no transaction fee
4 Critique of CAPM - no asymmetric information
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM) 1.All investors are rational risk averse investor.
2 Three main uses for CAPM
See the detail in Chapter6
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM) 2.All investors aim to maximize economic
utilities.
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM) 3.All investors are able to lend and borrow at
risk-free rate.
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
A MODEL OF COST OF CAPITAL
1 A Capital Asset Pricing
Model(CAPM) 4.Perfect Competitive
2 Three main uses for CAPM
3 CAPM Model
4 Critique of CAPM
4.6 INFORMATION ASYMMETRY
A CLOSER LOOK AT INFORMATION ASYMMETRY
• Adverse selection
• When one type of participant in the market knows
something about the asset being traded that another type
of participant does not know
• The unknown parameter is the honesty of the insider.
• Moral hazard
• Manager effort in running the firm is typically
unobservable, creating the possibility that the manager may
shirk on effort
• The unknown parameter is the extent of manager shirking.
In the face of information asymmetry
A CLOSER LOOK AT INFORMATION ASYMMETRY
• Inside information a source of estimation risk for investor
• Investor reaction to estimation risk
• The lemons problem (Akerlof (1970))
• Effect to a share in the presence of inside information
• Investors might withdraw from market, market collapse
• Investors pay less, to protect against estimation risk
A CLOSER LOOK AT INFORMATION ASYMMETRY
• Effect of estimation risk on share prices
• Efficient market price includes a “discount” for
estimation risk i.e., investors demand a higher return
• CAPM understates cost of capital, since ignores
estimation risk
