# Limitations of CAPM and Fama-French three-factor model

No introduction and conclusion needed

Straight into discussion

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The first part (275 words):

o Limitations of CAPM: Security Market Line (SML) using a single

factor (beta) when calculating investors' required returns, debt

cost of capital, the cost of capital (the appropriate discount rate

to calculate the net present value of Company A’s new

investment project)

for example The formula for required return using CAPM: r=����+β*(����-

����), where average ����= 0.136%, market risk premium ����-����=0.593%,

and the estimated beta β= 0.447. Therefore, the monthly equity cost of

capital using the Security Market Line is r=0.00136+0.447*0.593=0.446%.

Please state the limitations of using SML for calculating these

variables

o Limitations of the Fama-French (1997) three-factor model when

calculating investors' required returns, debt cost of capital, the

cost of capital (the appropriate discount rate to calculate the net

the present value of Company A’s new investment project)

For example: By using the Fama-French method, r= ����+β������(����-����)+

β��������(SMB)+ β����������(HML), where ����=0.136%, ����-����=0.593%, and

the β������=0.447, β��������=0.159, size risk premium SMB=0.339%,

β����������=0.0792, value risk premium HML=0.169%.

Therefore, the monthly required return on Company A’s equity

r=0.00136+0.447*0.00593+0.159*0.00339+0.0792*0.00169=0.454%.

Yearly equity cost of capital ����= (1+monthly rate)^12-1=

(1+0.00446)^12-1=5.49%.

Please state the limitations of using the Fama-French method for calculating

these variables

The second part (275 words): How to refine the above analysis given more

time and information, give suggestions

*PLEASE REMEMBER TO DISCUSS LIMITATIONS OF CAPM (SML) AND FAMA-

FRENCH THREE FACTOR MODEL IN CALCULATING INVESTORS' REQUIRED

RETURNS, DEBT COST OF CAPITAL AND THE COST OF CAPITAL IN FIRST

PART, DISCUSS HOW TO MAKE THE ANALYSIS BETTER IN SECOND PART

## ANSWER.
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Academic Level | Master’s |

Subject Area | Finance |

Paper Type | Critical thinking |

Number of Pages | 1 Page(s)/550 words |

Sources | 5 |

Paper Format | Harvard |

Spacing | Single spaced |