Capital Asset Pricing Model Essay Example | Topics and Well Written Essays - 2500 words

Capital Asset Pricing Model - Essay Example In most business, risks are often associated with each venture that entities partake. Logically, every endeavour can be affected by several stressors and will result to unsure forecasts. Indeed, firms are unaware of the exact benefits that an investment despite the forecasts provided by financial analysts. In determining the return that investments will likely provide, organisations make use of cash flows. Comparing the cash the flowed out from the investment to the cash that flowed in because of the investment appears to be a near accurate approach that results to better understanding of investment returns. Basically, there are certain tools and mechanisms used by firms to justify the use of cash flows. In particular, discounted multi-period risky cash flows are used to determine benefits coming from investments. Accordingly, the capital asset pricing model is one option that most financial analysts prefer. The succeeding discussions will tackle on the use of capital asset pricing model as basis for discounted multi-period risky cash flows. The prevalence of investments has led to several ideas particularly on the side showing benefits attributed to such activities. For investors, it is important to determine the exact amount that will be gained from the investment. Essentially, there were several methods developed to address this need. Taggart (1999) created capital budgeting analysis model that makes use of the discounted cash flow. Accordingly, this model enables investors to forecast the values of cash flow components. Among the models, this is considered as widely used because of the perceived precision. Another useful model was developed by Mahoney and Kelliher (1999), which focuses on the capital budgeting model that integrates uncertainty in the cash flow estimates. Using the Monte Carlo simulation, the model can serve as a practical and useful tool. The model, however, is embedded with higher level of complexity that can affect capital budgeting decisions. Moreover, Winston (1998) devised a model for multi-period capital budgeting using Silver Tool, which is an application in Excel. The model provides several advantages including selection of the best project considering all constraints and circumstances. Aside from the mentioned models, Ragsdale (2001) illustrated a model that uses Solver to determine optimal combination of capital budgeting investments as affected by capital constraints and maximising the Net Present Value. In this process, optimal selection of investment is ascertained considering vital risks that include the probability of success of minimum and maximum revenues with the other aspects previously mentioned. Data tables, as showed by Benninga (2000) can be used in capital budgeting analysis. The process involves computing for the point estimate of NPV, and the NPV is calculated using predetermined growth rates. The results are useful in evaluating the risk of the project with the given NPV ranges. Interestingly, Mayes and Shank (2001) focused on the use of different applications for capital budgeting analysis. This involves the collaboration of the models presented earlier in this discussion. Part of their model was to incorporate risk-adjusted discount rates and Monte Carlo simulation to evaluate project risks. According to Fama (1970), multi-period investment consumption can be associated with an individual's