Literature review Essay Example | Topics and Well Written Essays - 2000 words - 2

Literature review - Essay Example The model is basically represented in a mathematical equation which is equated with the â€Å"expected rate of return on a stock to risk free rate plus a risk premium for the stock’s systematic risk† (Keown, 1998, p.242). Risk premium for a particular security is basically defined as the required return after deducting the risk free rate existing in the market. Total risk which is calculated as a standard deviation of return is generally fragmented into two parts. They are unsystematic and risk systematic risk, Beta () (Strong, 2008, p.168). The investors are rewarded bearing through this risk only and is very crucial. The equation for CAPM can be given as follows: †¦Ã¢â‚¬ ¦Ã¢â‚¬ ¦.. (1) The above equation is a CAPM equation and it is also known as the security market line. In this equation, is the expected return, is the risk free return, is the required return for a particular market portfolio. , measure the systematic risk (Keown, 1998, p.242). 1.2 Application T he model provides a logical approach for analyzing the return that an investor should receive from an investment. More interestingly, the model is applied in a wide spectrum in the field of modern finance for the purpose of estimating the cost of equity and the performance of a company. Evaluating performance of companies in a particular industrial area is of great importance as it reflects the economic functioning of the area and further decides the strength of investor’s attraction in that particular area (Armitage, 2005, p.278). 2. Research Aims and Objectives The rationale thus created is that the CAPM model helps to calculate expected return of an investor and evaluate the performance of the companies. The concentration in this paper will be on the later trajectory i.e. performance of the companies. The aim of the paper is to find proper application of CAPM model in a real world scenario. The objective of the paper is centered on finding out the intensity of the companie s creating value for their shareholders with data on ten US companies listed in the New York Stock Exchange. 4. Research questions The research questions that will be discussed in this paper are discussed below: 1. What is the importance of CAPM model in corporate finance? 2. What are the fields where the model is applicable and what important results it yield? 3. What decision criterion the model generates that drives the financial managers to take important business decisions? 3. Research hypothesis The research hypothesis that will be tested in this paper can be represented in a tabular format as given below: H0: The companies selected are not performing strongly to create value for the shareholders H1: The companies selected are performing strongly to create value for the shareholders H0 is the null hypothesis which will be tested against the alternative hypothesis H1. The data and testing procedure will be explained in a detailed manner in the methodology section. Now, the subs equent section will focus on a brief literature review on this particular financial model i.e. CAPM. 4. Literature Review Rigorous testing has been employed with CAPM model in the last three decades. Studies of Jensen and Scholes in 1972, Blume and Friend in 1973, Reinganum in 1981, Banz in 1981 founded that there exist a positive correlation between the realized return and as well as that between risk and return is a linear function. Through the