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I would like to ask a question regarding CAPM. This is a question from the mock paper on the OpenTuition website.
Which of the following statements regarding CAPM are not correct?
1) The return required from an investment is related to its unsystematic risk
2) CAPM assumes that investors are well-diversed
3) CAPM ignores the effect of company tax
4) CAPM assumes that debt is risk-free
Ans: Statements 1, 3, 4
I do not understand why statements 3 and 4 are false.
According to this article on CAPM on the ACCA website (https://www.accaglobal.com/uk/en/student/exam-support-resources/fundamentals-exams-study-resources/f9/technical-articles/CAPM-theory.html) , the CAPM assumes that investors can borrow and lend at the risk-free rate of return. CAPM also assumes of having a perfect market – meaning no taxes and transaction cost.
Thank you for help in advance 🙂
The article to wrong to suggest that CAPM ignores the effect of company tax and is wrong to assume that debt is risk free.
The initial theory did assume that, but it was developed to include both.
If you look at the asset beta formula, it includes tax and it also includes a debt beta.
(When using the formula in the exam we always assume that debt is risk free and that therefore the debt beta is zero, as I explain in my free lectures. In real life debt will not be risk free (although the debt beta will only be small) but CAPM does cope with debt not being risk free.)