Evaluation of The Capital Asset Pricing Model (GlaxoSmithKline) Essay

Evaluation of The Capital Asset Pricing Model (GlaxoSmithKline) - Essay Example This model generated the idea of beta, that is, the risk of the specific stock. The CAPM model thus is mainly used by firms for estimating the cost of equity. CAPM Assumptions The CAPM model makes some assumptions for calculating the price of the securities which are risky. These assumptions are as follows : †¢ The market is efficient and perfect. The information regarding the market is easily available to all the investors. No single investor can influence the stock price change of the market. As the market is efficient there is no transaction cost, no taxes (kapil, 2011, p.168). †¢ The investors are risk averse in nature. All the investors have same expectation about the return from the market. It is also assumed that the assets are perfectly liquid and they are divisible infinitely. It means the investor can buy or sell any amount of stock. It is also assumed that all assets can be sold or bought in the market by the investors including the human capital. †¢ At the risk free rate the investors can borrow or lend unlimited amount and they can expect risk free rate of interest from the funds. †¢ Unlimited short selling is allowed as per the assumption of CAPM model. †¢ The investors are concerned with a single period price of asset and the mean and variance of the concerned asset (Elton et al, 2009, p.283). ... CAPM Limitations CAPM model is criticised because of the number of assumptions it makes. It is assumed in the model that the market is efficient which in reality it is not. The information regarding the market is not readily available to the investors. There is also the transaction cost of trading and the taxation cost which the model does not take into consideration. In the model it is assumed that the investors are interested only for a single period of change in the asset pricing. But in reality when they invest they do the fundamental analysis of the stock which means they analyze the historical value of the asset taking a long period into consideration. The beta of the asset changes over the period, it is not stable as assumed by the CAPM model. The investors are not also risk averse in nature and also it is not possible that the assets are divisible entirely. The relationship of beta and return is weak practically (Damodaran, n.d., p.13). It is also a factor that the firm may c hange in the period for which the estimation is made. Instead of these limitations, CAPM model provides the quantitative and logical tool for measuring the risk and return relationship of the asset or the portfolio. Part II GlaxoSmithKline Risk and Return Analysis About the Company GlaxoSmithKline, a company of the pharmaceutical industry was founded in the year 2000 and listed in the London stock exchange and the New York Stock Exchange. The company is a constituent of FTSE 100 index. The company is based in London and in terms of revenue it is the third largest company in the world. The company’s business is spread throughout the world. The long term