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Which of the following statements regarding the capital asset pricing model (CAPM) are NOT correct?
(1) The return required from an investment is related to unsystematic risk
(2) CAPM assumes that investors are well diversified
(3) CAPM ignores the effect of company tax
(4) CAPM assumes that debt is risk freea) statements 2, 3 and 4
b) statements 1 and 2
c) statements 1, 3 and 4
d) statements 1 and 3This was a question in the opentuition FM mock. The correct answer was C. Could you tell me why 3 and 4 are not correct ? Because from what I know CAPM assumes a Perfect capital market which means no tax and transaction costs and CAPM also assumes that investors can borrow and lend at the risk free rate.
c) So whilst the CAPM assumes a perfect market with no taxes and transaction costs…but it does not explicitly ignore the effect of company tax. The cost of debt to the company is lower due to tax relief on debt interest, which indicates that taxes are considered in the broader financial context.
And d) although the CAPM assumes that investors can borrow and lend at the risk-free rate, it does not assume that all debt is risk-free. The risk-free rate is typically represented by the yield on short-dated government debt, which is considered risk-free, but this does not extend to all forms of debt.
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