Q The assignment is about Capital asset pricing model in finance that explains the relationship between risk & returns. Home, - Capital asset pricing model (CAPM) Overview of CAPM The Capital asset pricing model (CAPM) made the noble prize for Sharpe in 1990. It was presented by Sharpe and John Lintner in the 1960s. The method was developed based on Markowitz's theory who was a founder to mean-variance model. The method is utilized in the determination of the rate of return and in the same way cost would also be determined. Markowitz (1959) show proposes that financial specialists pick a portfolio that will limit the fluctuation of portfolio return, given an explicit dimension of expected return, or amplify expected return, given an explicit dimension of change (Perold, 2004). What is the connection between the hazard and expected return of a venture? The capital resource valuing model (CAPM) gives an underlying system for noting this inquiry. The CAPM (Sharpe, 1964; Lintner, 1965) marks the introduction of benefit evaluating the hypothesis. This model depends on the possibility that not all hazard should influence resource costs. The model hence gives knowledge into the sort of hazard that is identified with the return. After four decades, the CAPM is still broadly utilized in applications. The CAPM gives an approach to making an interpretation of hazard into assessments of expected ROE. Its application keeps on producing banter: numerous researchers contended that the CAPM depends on unlikely suppositions. This paper spreads out the key thoughts of the CAPM, the historical backdrop of exact work on the CAPM and the ramifications of this work on the deficiencies of the CAPM. Each money related choice contains a component of hazard and a component of return. The connection between hazard and return exists as a hazard return exchange off, by which it is implied that it is just conceivable to gain higher returns by tolerating higher chance. On the off chance that a financial specialist wishes to gain higher returns, the speculator must welcome that this may be accomplished by tolerating a proportionate increment in the hazard. Hazard and Return are decidedly related; an expansion in one is joined by an expansion in the other. The suggestions for the budgetary supervisor in assessing a forthcoming speculation venture is that a viable choice about the undertakings incentive to the firm can't be made basically by concentrating on its dimension of restore; the ventures dimension of hazard should likewise be at the same time considered. This hazard return exchange off is key to venture. In money related administration today the treatment of hazard is the fundamental component in monetary basic leadership. Key current inquiries include how hazard ought to be estimated, and how the required return related with a given hazard level is resolved. A substantial body of writing has created trying to answer these inquiries. Nonetheless, chance did not generally have such a conspicuous place. Preceding 1952 the hazard component was normally either expected away or treated subjectively in the budgetary writing. In 1952 an article by a financial expert, Markowitz (1952) proposed a ground-breaking yet straightforward methodology for managing hazard. In the two decades since the cutting edge hypothesis of the portfolio, the executives have developed. The Capital Asset Pricing Model was initially derived independently by Sharpe, Lintner, and Mossin. Treynor, Sharpe and Jensen measures added weight to the model and improved it beyond the standard CAPM. Though it is regarded as one of the great breakthroughs in the world of Finance and used by Finance executives all over the world it has some shortfalls primarily attributable to its assumptions. Assumptions of the CAPM model: 1. The absence of institutional friction like transaction costs. If transaction costs were included the model would get complex. 2. Ignorance of Personal Income Taxes. 3. Assets are assumed to be infinitely divisible. 4. Perfect Competition is an important assumption of the model and prices of assets can't be influenced by individual and institutional investors single-handedly. (Although, historically we have cases of seeing this happen). 5. Homogeneity of expectations from investors. The CAPM apart from its assumptions considers only one stimulus that affects an investor's return (Company's Cost of Capital) in the form of returns prevailing in the market (both with and without risk) The Arbitrage Pricing Theory. The APT model solves the biggest limitation of the CAPM using the help of multiple stimuli and a separate sensitivity ratio (Beta) for each stimulus. The relationship between risk and return in the securities markets. Risk factors Associated in Stock Market Investments: Stock markets are absolutely secure, but they are risky for common investors. Risk depends on stocks, which you have selected for investment. There are low-risk shares, but there are no risk-free shares. The extent of risk depends on various factors, some of these are: Individual stocks you invested: Risk depends on individual companies. In general large-cap stocks are of low risk, but small-cap companies, especially with high promoter stake, are of high risk. All BSE 30, NSE 50 stocks and stocks with good brand value compromises of low risk, even they are corrected, have the ability to actively rebound. Investment at peak of stock market rallies is highly riskier (as Rally-Correction are Cyclical). Who invested at starting phase of rally gains good profits.Example, investment at 2008 December Peak returned high risk, paid off huge losses. Conflictingly, investment on 2009 march Dips is good timing and returned good profits. Also, stock markets are widely affected by global and national economic factors, rumors (for short-term only), inflation, commodities alterations, companies quarterly results, industrial production, GDP numbers, economic surveys and reports etc. a lot of factors… All these ‘Market Factors' when negative to stock markets can be considered as risk factors. The study of all risk factors, their co-relation among them and with individual stocks, their intensity, future violence they would create, is a matter of complex science. These are some directions to Tolerate the Risk: Select shares of BSE 30, NSE 50 index. (Especially of brand value). Avoid low float value stocks. Follow systemic investment. But also risk varies, depending on the security you bought Future trading (highly risky) Options trading (relatively low risk than futures, but high risk than cash segment) Cash market/direct shares (comparatively low risk than above two) So always consider the risk factors before investing your money in stock markets, but no fear. Simply follow Long-term investments, the best technique to avoid Risk factors Associated in Stock Market Investments Warren Buffet once said, ‘Risk comes from not knowing what you are doing’. Share market investment may be commonly associated with risk, but this is not the case. The price of the shares depends on its demand in the market, which is directly linked to the company's performance. Investing in the shares of a company that is performing well is what makes the most sense in the market. However, investing in companies which are expected to perform well in near future are considered the best investments, as they reap high returns. Often the future performance is speculated based on word of mouth and investments based on these speculations involve high risk. However, if investments are made on researched information about a company provided by professionals who monitor the performance of companies and the market constantly, the risk is minimized. Several market leaders like Karvy Stock Broking, Motilal Oswal, and likes to publish regular reports which are backed by strong research. Investing based on these minimize the risk and enhance the potential returns. Many commonly believe that investing in the stock market involves high risk, whilst investing in mutual funds is safe. However, they do not realize that the value of mutual funds to is indirectly related to market performance. Broadly terming stock investment is not completely correct. Market risk is more of a calculated risk, here the severity of risk depends on the selection of investment. A well-researched investment in a stock is not as risky as investing in a random stock or choice. Thus it is always recommended to invest in stocks recommended by experts and stay away from investing in penny stocks. Returns Return on equity (ROE) is the profits or income you generate per year for each unit of your own money you've invested. As a formula, ROE = profits/equity invested. For companies, we often use average net-worth (or book value) as invested equity. For individuals and companies, ROE should be the single most important metric that decides whether or not to invest in an asset or project. Simplistically, you would compare ROE with the cost of equity (or at least opportunity cost) in order to make such a decision (Hirshleifer and Luo, 2001). Side-note: ROE is similar to return on invested capital (ROIC) except invested capital includes any leverage or debt you've taken as well. In other words, ROE = ROIC * (leverage = Invested capital/ equity). With great leverage comes great ROE but greater responsibility. Hence, it is advisable to consider ROIC as well apart from ROE since you don't want to be making money only from leverage. How to calculate return on equity ROE = Net Income(After Tax)/Shareholders'Equity(No of equity shares). Net income is for the full financial year (before dividends paid to equity shareholders but after paying dividends to preference shareholders.) Preference shareholders are not considered as the Shareholders Equity. Overall a 15%-20% ROE would be considered to be good. When we make an investment in the company first we look at the ROE than the risk involved in it, which is commonly measured by the leverage ratios. High ROE, Low leverage - It is often an indication of a good business, Its a well established and financially sound company, This must be the Investors first choice... High ROE, High Leverage - It denotes the company is trying to climb a mountain. It may reach the top level or may suddenly fall to the bottom. Always know about the companies management, how efficiently they are managing their business and finances before buying such stocks... Low ROE, Low Leverage - It shows the business is running very slowly, The return on investing in such business are also low. It's better to avoid investing in such companies and invest in some high-quality bonds which results in the same return on your investments. Low ROE, High Leverage - A disaster waiting to happen. The volcano is ready to burst. Investors should keep a distance from such business or company and run away from them by selling the stocks that you own. The relationship between risk and return is directly proportional to each other. When you want to achieve something big then you may need to put some bigger things at the risk. If you are not willing to take a risk, then you will not get profit as well. For example, you want to get rich, but you are not ready to leave your job, then you cannot get rich in any condition. To get rich, you will have to think out of the box, you will need to create a way by which you can have more money. That means you may need to leave your job and you will have to invest a lot of efforts as well. however, you never know if your business or the things that you are doing will make you rich and that is the risk with it. But if you take the risk and you get success then you will have a higher chance of getting rich. That means you will have more profit. You can check the history, all the people that got any profit or success in their life they got it only because they took the risk. So, if you want to have something big, start taking the risk. Typically, investments with greater risk have the potential to provide greater returns. For example, a typical savings account returns may .05 percent a year. However, historically the stock market has earned average or returns of about 6 percent annually. Now we all know the stock market can crash and leave you with huge losses. The way to mitigate this is with dollar cost averaging. That is simply investing monthly the same amount of money. By doing this you buy shares at low prices and higher prices so the declines do not affect you as negatively. Remember, bulls can make money and bears can make money but hogs never can. The risk is the probability that an asset's market value will fluctuate over time. Price volatility. For obvious reasons, an investor is more worried about the negative risk than the positive risk. The risk-averse investor will seek an investment with low risk - typically a government bond or by placing the money in a safe bank account. He will receive a low-interest income (return), but the risk of losing his investment will also be very low. Investors who are willing to take more risk will demand a risk premium on top of this risk-free return corresponding to the probability of the negative risk involved. It is no easy task to estimate the risk involved with an investment. The outcome can be either binary (either or), linear (more or less) or entangled with other occurrences (A leads to B etc.). Therefore, the risk premium that the investors demand is often higher than the actual risk. Market scenarios: Risk-on vs. Risk-off • Risk-on: It occurs usually when market risk (i.e. volatility) is expected to be lower. Hence, risk-on rally takes place when investors chase risk assets (like equity) due to a higher expectation of market returns. Preference for high-risk stocks (i.e. high beta relative to the market) usually increases in the risk-on scenario. • Risk-off: It occurs usually when market risk (i.e. volatility) is expected to be higher. Hence, risk-off takes place when investors shun risk assets (like equity) due to lower expectation of market returns (Fama and French, 2004). Preference for high-risk stocks (i.e. high beta relative to the market) usually decreases in the risk-off scenario. Investor types: Conservative vs. Aggressive • Risk-averse (conservative investor): lower preference for high volatility assets • Risk seeker (aggressive investor): higher preference for high volatility assets Typically, investments with greater risk have the potential to provide greater returns. For example, a typical savings account returns may .05 percent a year. However, historically the stock market has earned average or returns of about 6 percent annually. Now we all know the stock market can crash and leave you with huge losses. The way to mitigate this is with dollar cost averaging. That is simply investing monthly the same amount of money. By doing this you buy shares at low prices and higher prices so the declines do not affect you as negatively. Remember, bulls can make money and bears can make money but hogs never can. There is no direct or automatic relationship between risk and return. The risk is the probability that an asset's market value will fluctuate over time. Price volatility. For obvious reasons, an investor is more worried about the negative risk than the positive risk. The risk-averse investor will seek an investment with low risk - typically a government bond or by placing the money in a safe bank account. He will receive a low-interest income (return), but the risk of losing his investment will also be very low. Investors who are willing to take more risk will demand a risk premium on top of this risk-free return corresponding to the probability of the negative risk involved. It is no easy task to estimate the risk involved with an investment. The outcome can be either binary (either or), linear (more or less) or entangled with other occurrences (A leads to B etc.). Therefore, the risk premium that the investors demand is often higher than the actual risk. If I take on more risk, I should be compensated with a higher rate of return. A key theme across investment finance, the relationship between risk and return comes to us from our own human nature: risk aversion. We mostly prefer safe investments. The point at which we are willing to give up a safe & guaranteed investment in order to pursue a risky investment is called the certainty equivalent. Since financial investments are risky, investors will require a risk premium. In order for me to hold a riskier stock or portfolio, I’m going to need to be compensated with more return. The amount of that extra compensation is the risk premium, and thus the certainty equivalent of choosing to invest more money in a risky asset. Of course, the risk premium can be different for everyone depending on your level of risk-tolerance (Ross, 2013). Some are more risk-averse than others and will require more compensation for making risky investments. To model this dependency on individual risk-aversion, we use a utility function. The utility can be thought of as "happiness", which all of us are trying to maximize. Investors will choose the opportunity that yields the highest utility. For investment finance, we typically use the following utility function, where: U = utility E(r) = expected the rate of return on the portfolio of assets. V = variance of the asset or portfolio A = coefficient of risk-aversion Thus, as A increases utility decreases, meaning that the expected return must increase for the utility to reach a certainty equivalent. Models like the CAPM try to incorporate these ideas and still fail to do so. A key area of financial research is still attempting to reconcile the low-volatility anomaly to these simple ideas of risk-aversion. The risk is the chance of an investment gaining or losing. There are many types of risk in finance, the most common risks include Market risk, Interest rate risk, Currency risk & Credit risk (there are many more types of risk). Return is the value you receive from an investment. For example, you invest £1,000 into company A. 1 Year later the share price has doubled and you decide to sell (Perold, 2004). Your return would be £1,000 profit. However, if the share price fell by 50% and you sell to cut your losses, your return would be negative £500. Risk and return in finance come hand in hand. Usually the more risk you take the higher the expected returns. Risky investments increase your chances of loss so for this increase in risk you expect to receive higher returns from the investment. If you invest in less risky products such as government bonds you will receive smaller returns. The risk is investing your earnings in the businesses which may provide returns based on its performance. Risk can be known upfront by evaluating the underlying that is assessed. But the return depends on the intrinsic and extrinsic factors, the intrinsic factors can be determined using the fundamentals and the extrinsic factors depend on several factors that influence the business which may vary as per economy. The current zero risk (risk-free) return you can make is by investing in government savings scheme bonds. The risk-free return you get is 7.75%(the actual returns post-tax will be lesser) P.A paid out half yearly. The tenure of the bond is 7 years. If the same amount is invested in a large-cap mutual fund or a blue-chip stock, it may yield returns of 12–15%, but the risk here is that it is possible that the capital may get eroded by the market forces. The risk-return trade-off is the final risk at hand considering the safe return that you have (government security) vs Market returns. Is it worthwhile for you to take the risk and absorb the loss in the event of the worst case scenario? Finance in simple terminology means arrangements and management of necessary funds which are required by organizations like firms, Individuals or big corporations for achieving their objectives. The study of investment on any business organizations is term as finance. The main role of finance is to price assets based on their risk level and their expected rate of return. It includes the dynamics of assets and liabilities over time under conditions of different degrees of uncertainty and risk, it is also known as the science of money management. Advantages, disadvantages and appropriate criticism for CAPM model Advantages Mutual Funds and Banks use this model, or actually variations of the model that have created to determine which investments are better than other investments. If you were to apply the 60 stocks to the CAPM, it would give you the expected return of those stocks. Taking it one step further, you could divide the expected return of each stock by the beta of each stock. This value that you would get is called the Risk-to-Reward Ratio which attempts to tell which stock is a better investment based on how much risk and how much return is apart of each stock. So the higher the risk-to-reward ratio, the "better" the investment. This ratio and the CAPM are not completely reliable for predicting the stock prices. In fact, I was you, I would not use the original CAPM to predict the prices of stocks and invest based on that information. However, I would use it as a tool in determining which stocks you invest in. I recently completed my research paper on the CAPM and tested whether or not its predicted returns were similar or even close to the actual returns of stocks. Not to my surprise, the model did not accurately predict the prices of the stocks, but only one stock's expected return was within ±20% of the actual return. This was slightly discouraging considering the time I put into the paper, but I was able to write a good conclusion on why it isn't perfect (Liu, 2006). However, it is useful because it introduces many important concepts in finance, such as the Beta, risk-free rate, risk premiums, market efficiency, and many other things. It may not have been the first to introduce these things, but it is a great tool for beginning to learn about the world of asset pricing models. The CAPM model has not always been reliable in predicting asset returns that actually occur compared to the model. Although plenty of evidence suggests that the CAPM is flawed in many ways because of the assumptions it relies on plus one study claims to have proven that the model asks for identical returns for differing amounts of risk; still it seems to be the de facto standard. Some quantitative traders have built their own predictive models which are proprietary to the Banks or shops that use them. CAPM has always had its critics and there are variations of the model which modify it slightly but the market portfolio is still plotted on the efficient frontier including a diverse group of securities. Whether it makes sense in a practical manner to use this exclusively to determine expected return for a portfolio of stocks or bonds; there are other methods such as the Arbitrage Pricing Theory that can be used. However, the key is to beat the comparative benchmark. Alpha is the measurement of positive or negative returns against the benchmark portfolio. For the same level of risk accepted in the market if your portfolio outperforms the benchmark by 7% then your alpha is 7. This is what you really want to achieve. Pros: • Market portfolio appears very hard to beat in real life • Simple to understand and implement • Consistent use for investment science and corporate finance • Equilibrium model (no internal contradiction) Drawbacks CAPM gave us the first priced factor in expected returns (i.e. the market return). Right now we have more than 400! Before going into its drawbacks let me put forth its merits. 1. It's easy and intuitive. You can explain it to a school student. 2. It is theoretically driven. If the assumptions of homogeneous expectations and return normality were to be true, then CAPM holds in principle. 3. It is easy to compute. All you need is returns data and a calculator (or excel) When it comes to drawbacks, they also happen to be closely related to its merits 1. If CAPM is true then determining expected returns is literally a cakewalk. It’s hard to internalize that a place as diverse and dynamic as the stock market could be driven by such a simple linear rule. 2. The devil in applying CAPM lies in its assumptions. People often focus on the assumption of Normal returns. In reality, CAPM only needs that the investor’s utility (happiness) increases with the higher mean return and decreases with higher return variance. Normality is just for tractability. a. The bigger assumption is of homogeneous expectations which say that all investors agree on return distribution. This is too much to ask. It basically means that everyone has the same information (and expertise) about the market. b. Other mistakes most people often make is that CAPM holds in expectation NOT in realized returns. A stock with high CAPM beta is “expected” to give higher returns. It doesn’t say when will the returns materialize. 3. CAPM is a single period static model meaning that it doesn’t take care into market dynamics which most noticeably materializes as varying beta. Yes, CAPM beta is not constant over time and there is no ONE way of estimating it precisely. CAPM is a very basic level of project management certification for someone who doesn't have the level of experience to qualify for PMP certification. It's only of value if you don't qualify for PMP. And, any certification (PMP or CAPM) won't get you very far unless you have some actual experience to back it up (Holton, 2013). So just getting a CAPM certification without any actual experience will have limited value but it's better than nothing. The other disadvantage of both CAPM and PMP is that both of those certifications are focused on a traditional, plan-driven approach to project management and many companies are moving rapidly towards an Agile Project Management approach in heavily technology-driven areas such as software development. Unfortunately, at this point in time; Agile and traditional, plan-driven project management are still treated as separate and independent domains of knowledge with little or no integration between the two. Cons • Fails to test an individual security level • Equilibrium model (assumes agents are homogeneous) • Single factor model and ambiguity on the investable universe (Home bias for instance) • 1960’s technology Criticism My understanding is that CAPM was formed and developed on the basis of portfolio theory and efficient market theory. CAPM assumes that investors are rational and that they diversify their investment portfolios according to the rules of Markowitz Model selecting their portfolios from somewhere on the efficient borderline. It also assumes that the capital market is strong form efficient, no frictions to obstruct investing (Gatfaoui, 2010). CAPM cannot hold to its ground without the supporting role of portfolio theory and efficient market theory. Besides, it uses Beta as a measure of risk. The previous experiences have shown that Beta couldn't make sufficient explanations for return, especially common stock portfolio return. Comparison amongst actual return and return based on the CAPM model of a firm listed in Abu Dhabi AGTHIA Group PJSC The company belongs to consumer staples sector incorporated and listed in Abu Dhabi. In the above-given chart, we have compared the historical returns of the firm with the CAPM return from 2008 to 2015. In the earlier years, we can see that there is a high gap between the actual return and CAPM return. The diagram concludes the weakness of the CAPM model to predict the actual rate of return of the company over the years (Emery, et al., 2004). The current market price per share of the company’s stock is AED 3.85. And the return of the company over its equity investments as of the last year from the current date in actual is 10.06 percent (Amihud, et al., 2006). The beta of the company as compared to the consumer staples industry is 0.85 and the rate of return therefore as per the CAPM methodology is calculated hereunder as on 12th of December, 2018. Rate of return (CAPM)= Rf+ B(Rm-Rf) = 4.5%+ 0.85(6.5%-4.5%) = 6.20% Level of debt and equity comparing to the optimal capital structure in that industry. Optimal Capital Structure Note that this concept of an optimal capital structure is largely theoretical. In the real world, there are plenty of other factors affecting capital financing that are not captured in such theoretical models. For instance, a company with volatile revenues might want to keep low debt levels since interest payments are mandatory, regardless of the company's performance, while dividends are discretionary (Norman, 2014). For another, low debt levels mean high credit ratings, which have a managerial ego factor associated with them. Whether this is in the best interests of shareholders is another matter. In conclusion, the optimal capital structure serves as a good long-term indicator of where a firm might be headed with its debt/equity mix, but in the short run, you'll often find companies deviating greatly from the optimal for genuine, legitimate reasons. The optimal capital structure (debt/equity) depends on the industry the business operates in and how efficient a company operates (ability to produce cash flow) Because your question gives no specific metrics the real answer is it depends. In general equity financing is ideal. However when taking things like debt covenants, cost of debt, and again the efficiency of the company; a high debt/equity ratio may be justified and encouraged. Determination of Optimum capital structure You develop a comprehensive three-year operating-plan composed of individual disciplines such as sales, marketing, services, development and F&A, from which income statement, cash flow, and use of proceeds are computed. From those assumptions, modulated by your own assessment of risk, comes the capital requirements needed to run the business through its transitional periods. Setting up the operating plan is not the magic, walking through it with a founder gives a remarkable insight into the business, the process of gathering the information and discovery often instrumental in leading to decisions as to how to focus on the business on producing optimal profit margins. Like how I once dissected a medical business and discovered how the business had diluted its profit margins by focusing on too many product lines. Returning it to becoming the king of one, rather than the king of none. Nothing beats a great vision of a product or service to produce value, but without a strong operating plan to support the viability of its realization a vision remains just that. Having completed the operating plan is also a fantastic instrument in fundraising efforts, as the time spent on walking through the variables of the plan feeds potential investors the dog-food to make a viable investment decision, for you are now talking their language; finance. Optimal structure is that which minimizes the costs of capital in terms of the weighted average cost of capital (Nissim and Penman, 2001). Usually, debt costs less than equity because it has a priority in terms of repayment in case of failure or bankruptcy (Norman, 2014). After debt ratios are at a maximum, equity is used, but is more expensive, and therefore increases the weighted average costs of capital. Example: 50% of capital is debt at 12% combined with 50% of capital is equity at 20%, leads to a weighted average cost of capital of 16% for the firm. Anything that is "optimum" has to have criteria. I can think of many criterions to determine the optimal capital structure. For example; at the time of acquisition, one wants to have a CC that yields ROI and at the same time can service the debt. High debt means good ROI, but may not be able to service the debt. High equity means, low ROI but can service the debt. This inverse relationship between ROI and debt-service can help determine the optimal capital structure for acquisition. Minimizing WACC is a good objective at the point of acquisition but not sufficient. Hence it is not a criterion for optimal CC. For an existing business owner, he/she cannot change the business value by borrowing more to lower its WACC. Ideal debt to equity ratio The ideal debt to equity ratio is 1. Let us take an example: Suppose a company’s shareholder’s equity is Rs. 10,00,00 and total debt is Rs. 15,00,000. Then the debt to equity ratio is 1.5. This means that the company is having higher debt to equity ratio as it is more than 1. The significance of Higher Debt to equity ratio: The company has been aggressively financing the growth with its debt if it has higher debt to equity ratio. It is an indication of high risk. Such companies get impacted by adverse macro factors such as rising interest rate and the weakening rupee. Depends on the industry and the company in question. Key factors are: • stability of sales • predictability of cash flow • general credit terms with suppliers and customers Your equity needs to be large enough to absorb fluctuations in earnings and cash flow. If you have too little equity, you are at a risk of illiquidity or a take-over. If you have too much equity, you might get poor returns on equity (which is why very cash-rich companies pay large dividends or buy back shares). Generally speaking, it is usually somewhere between 10% and 60%. If the debt to equity ratio is less than 1 its a good thing. But see that ratio and compare the same ratio for the past 5 years at least. Because it can happen that a company's debt to equity ratio is less than 1 but ratios are increasing for the last 3 years which may or may not be a good sign. It varies by company (Norman, 2014). Things like the volatility of the stock price, physical assets, and cash flow all come into play b In addition, the new tax law means less of a tax shield from debt, so the debt to equity ratio will go down for most companies. Therefore, it can be concluded that the debt and equity ratio as per the industry shall be 1:1 based on the capital structure of the industry. Conclusion As per the requirements of the assignment we have successfully explained the core concepts in relation to CAPM methodology, how its calculated, what are the uses, why it is used, advantages of using this methodology, disadvantages and limitations that shall be considered while using this methodology, and calculation of CAPM return and comparison of CAPM return with the actual return of the Abu Dhabi based firm. Also, we have determined the level of debt and equity ratio and it is concluded that the ideal debt to equity ratio considering the other industrial parameters is 1. Even though other factors also affect the debt and equity position of the company such like inflation rates, interest rates, etc. that deviates from country to country. Debt in a company shall be therefore maintained up t0 level of equity or otherwise the company is said to be a risky company to invest in. Investment in the company through debt is also favorable to the companies because of low cost in form of interest and tax advantages on the interest charged as an expense. Further, we have discussed the associated terms for the purpose of a relationship of debt and equity ratio towards the capital structure of the industry. We have therefore explained the capital structure of the firm and what are the elements and functions to determine the capital structure.