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The Capital Asset Pricing Model (CAPM) is a pivotal financial theory that helps in determining the expected return on an investment by considering its risk. It involves the risk-free rate, the beta coefficient, and the expected market return. CAPM's formula, assumptions, and its global perspective with ICAPM are discussed, alongside its strengths, weaknesses, and practical applications in corporate finance and investment valuation.

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## Definition and Importance of CAPM

### Fundamental concept in modern finance

CAPM is a widely used model in finance that helps quantify the expected return on an investment based on its risk

### Two ways investors are compensated

Time value of money

Investors are compensated for the time value of money, meaning the potential return they could have earned by investing elsewhere

Additional risk

Investors are also compensated for taking on additional risk, as reflected in the beta coefficient

### Crucial for investors and financial professionals

CAPM is an essential tool for determining the risk-adjusted required rate of return for different assets, guiding investment decisions

## Elements of CAPM

### Risk-free rate (Rf)

The risk-free rate is the theoretical return of an investment with no risk, often associated with government bonds

### Beta coefficient (β)

The beta coefficient measures an investment's sensitivity to market movements, indicating its relative market risk

### Expected market return (ERm)

The expected market return is the return that investors generally expect from the market as a whole, typically estimated by the performance of a major market index

## Assumptions and Limitations of CAPM

### Simplifying assumptions

CAPM is based on assumptions such as rational and risk-averse investors, shared investment horizon, and access to all necessary information without costs or taxes

### Discrepancies between expected and actual returns

The idealized assumptions of CAPM may not always align with real-world conditions, leading to discrepancies between expected and actual returns

## Calculation and Application of CAPM

### Formula for calculating expected return

The CAPM formula calculates the expected return as the sum of the risk-free rate and the risk premium, determined by the investment's beta and the market risk premium

### Use in project evaluation and cost of equity

CAPM is valuable in corporate finance for estimating the cost of equity capital and in investment valuation, such as assessing the expected return on a new project

### Practical applications in the industry

CAPM has practical applications in various areas of finance, informing strategic financial planning and investment analysis