I wrote this paper. Question at end. Need a response.

Weaknesses and Strengths in the Capital Asset Pricing Model (CAPM)

The CAPM model has both strengths and weaknesses. One of the strengths is the ease of use. There is the simplicity of the use of the model, therefore, providing confidence for a range of possible outcomes for the expected rate of return. CAPM also considers the diversification of a portfolio; this is a concept where unsystematic risks are minimized through a combination of different stocks. Additionally, CAPM considers other models, such as the dividend discount model and the systematic risks throughbeta. The CAPM model's weakness is about risk-free rate; this is because the yield on government bonds keeps changing, and hence hard to find an acceptable rate (Vernimmen et al., 2022). Another weakness may occur when the return on the market is negative. The SML line shows a graphical representation of CAPM below

The SML line shows undervalued and overvalued stocks when it is applied in CAPM. This, however, has various weaknesses, such as assuming the market participants are rational, there are multiple risky assets, and the investment horizon is the same for all investors. The variation in risk-free rate and the changes in the expected return can be shown below

Assuming the market return is 6%, beta is 1.2, and the risk-free rate is 2.5%

If there is an increase in the risk-free rate from 2.5% to 3.5%, the expected return is

Expected return = 3.5%+1.2(6%-3.5%) = 6.5%

The increase in the risk-free rate causes an increase in the expected return, as shown above.

Debt and Equity financing

Most firms utilize equity and debt financing in their capital structure. Debt financing is utilized through borrowing from financial options or issuing bonds. This is then repaid using an interest rate. Equity financing is obtained through the issuance of common stocks. Equity investors provide financing to organizations in exchange for ownership through shares. Every method has demerits and merits despite providing funds to a business. Debt financing can be pricey, particularly if a company has a poor credit rating. In contrast, equity financing calls for selling a company's ownership and allowing investors to have a say in operational choices.

Interests accrued are usually paid for long-term and short-term loans after an agreed period. Capital is usually not repaid, and it is raised through preferred stock, ordinary stock, and retained earnings. The fact that the ownership of a business is not diluted makes debt finance to be favored by businesses (De Matos, 2018). I would recommend debt finance because it has the effect of maximizing the wealth of shareholders. The interest on debt is tax deductible and hence preferred by many firms. It is, therefore, more viable to utilize debt than equity financing.

References

De Matos, J. A. (2018). Theoretical foundations of corporate finance. InTheoretical Foundations of Corporate Finance. Princeton University Press.

Vernimmen, P., Quiry, P., & Le Fur, Y. (2022).Corporate finance: theory and practice. John Wiley &

Need response for below:

You raised a good point regarding SML. Debt financing entails the aspect of financial risks to its sector.

Debt financing is money borrowed from a creditor at a fixed rate of interest and with a fixed maturity date. Debt may take the structure of a loan or the sale of bonds. The creditor preserves a right to the money advanced and may claim it back under circumstances specified in the borrowing prearrangement.