What practical problems are encountered in using the CAPM to estimate common equity capital cost?

Question

What will be an ideal response?

Answer 1

Using the CAPM requires that we obtain estimates of each of the three model variablesNrf, ?, and (rm?? rf ). Let's
consider each in turn. First, the analyst has a wide range of U.S. government securities on which to base an estimate of
the risk-free rate (rf). Treasury securities with maturities from 30 days to 20 years are readily available. Unfortunately,
the CAPM offers no guidance about the appropriate choice. In fact, the model itself assumes that there is but one
risk-free rate, and it corresponds to a one-period return (the length of the period is not specified, however).
Consequently, we are left to our own judgment about which maturity we should use to represent the risk-free rate.
Second, estimates of security beta (?) coefficients are available from a wide variety of investment advisory services,
including Merrill Lynch and Value Line, among others. Finally, estimating the market-risk premium can be
accomplished by looking at the history of stock returns and the premium earned over (under) the risk-free rate of
interest. The market-risk premium is not fixed. It varies through time with the general business cycle. In addition, it
appears that using a market-risk premium somewhere between 5 percent and 7 percent is reasonable when estimating
the cost of capital using the capital asset pricing model.