APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model Research Paper

APT- Arbitrage Pricing Theory and CAPM-Capital Asset Pricing Model - Research Paper Example In the action of comparing investments’ returns and risks, if CAPM or APT is well utilized, they will reflect on whether one ought to invest in a given firm or another. The formulas to these two methods are given under; CAPM Re= Rf + ÃŽ ²*(Rm – Rf) Where; Re = Required return rate Rf =Risk-free return rate ÃŽ ² = Beta, which is the market risk factor premium Rm = Expected overall market return rate (valuebasedmanagement.net, 2011) APT Re = Rf + (Individual risk factor premium*Relationship between the factor and price) + (Individual risk factor premium*Relationship between the factor and price) Generally, these two methods are different in that one (CAPM) uses beta- which is the risk factor of a given stock in relation to that of the market. Therefore, if beta equals 1 this stock is equally risky with the market, if it is 2 the same stock is twice risky in comparison to the market. While on the other hand, APT utilizes individual factors in place of beta. Also APT does not apply the market return rate and thus considered to be more particular to a given stock in focus. CAPM’s data is objective while APT applies data from a single stock. Thus, CAPM is recommendable to an investor who is relatively dormant as compared to APT, which if correctly applied is better placed to assess projects. (Grover, 2010) Some authors have applied APT and compared the resultant estimates with those of CAPM. Patterson notes one of the cases where such has been done is the electric utility’s, written by Ross and Roll in their 1983 book. According to Patterson the end results of APT were credible in comparison to those of CAPM. But, this was without enough justification of the results. (Patterson, 1995 p151) Besides the first two, there are methods of assessment like the Dividend Growth Model and Modern Portfolio Theory. The Dividend Growth Model shows the value of ordinary shares in present value of the prospected future flows of cash which has been invested by an investor. The receivable cash inflows are taken as dividends as well as the expected price in future while the stock will be disposed. An ordinary share usually does not possess maturity and thus, it is held for numerous years. Therefore, a general ordinary shares’ valuation introduced by Gordon would be as below; P0 = ?t= 1â₠¬ ¦? Dt/ (1+r)t Where; Dt = dividend in duration t P0 = current stock price in the market r = constant yearly rate of growth of dividends t = number of given durations of periods (Siegel, et al 1997 p140) Just to mention, the other model investment assessment is known as MPT- Modern Portfolio Theory. This is a theory applied by investors who are risk averse and at the same time they want to achieve maximum or optimum level of expected return which is based on the market risk level. It emphasizes that risk is inherent in the process of getting the rewards associated with it. MPT is sometimes called the ‘Portfolio Management Theory’. As per the argument of this model, it is a possibility to come up with an efficient frontier that depicts optimal levels of a portfolio giving the maximum rate of expected return at the given risk levels. (investopedia.com, 2011) The study is set out to explain that the most recommendable model in the assessment of investment projects is CAPM . First things first, though, since lack of consideration of the assumptions would not lead to a comprehensive outcome of the study. The model of CAPM has the assumptions mentioned below forming its basis; Persons seek to achieve maximum utility of their investment portfolio over a given duration of planning horizon, Persons involved are risk averse, Persons have expectations