Describe the Capital Asset Pricing Model (CAPM) and how it is used in

Describe the Capital Asset Pricing Model (CAPM) and how it is used in capital budgeting decisions.

What will be an ideal response?

ANSWER

CAPM is a procedure for adjusting a measure of the required rate of return on a firm’s stock for risk. This risk-adjusted measure of the required rate of return on a firm’s stock is used as the opportunity cost of capital in equity financing of a capital project. The projected cash flows from the project are discounted back to a net present value using this risk-adjusted rate of return. The risk adjustment is based on the Beta value of a firm’s stock: the ratio of the volatility in the rate of return on a firm’s stock to the volatility in the rate of return on a market portfolio of stocks.