The first work on the model was done by Treynor (1961) and Sharpe (1964) (Galagedera, 2007). According to Galagedera (2007), one of the most important tasks of being the financial analysts is to identify the cost of equity capital. The capital asset pricing model is the most useful tool to analyze securities and afterwards determine the estimated return on investment. The method provides a way to measure risk quantitatively and translating that risk to determine the estimated return on equity. The principle advantage of Capital asset pricing model is the unbiased nature of calculated cost of equity that model attempts to calculate. CAPM cannot be used in isolation as managers use it in conjunction with other methods and base their results according to their own judgment (Galagedera, 2007).
Lee & Upneja (2008) in their study discussed that CAPM is the simplified application of financial market pattern and is generally employed to calculate the cost of equity capital. Regardless of the limitations, the model provides a useful tool to the financial manager to assess the behavior of any stock (Lee & Upneja, 2008).
As discussed by Laubscher (2002) the recent financial theory is based on the two assumptions i.e., securities market is competitive by nature and highly efficient which essentially implies that relevant information about the stock of any company is readily accessible and financial markets are composed of investors who try to do everything to maximize their return from the money being injected by them. The first assumption takes into account the fact that financial market consists of well-aware traders and the second assumption sheds light on the behavior of investors as to their willingness to earn more and more profit and bear less risk. Moreover, practical investors demand a premium in the form of higher return for the risk being borne by them. Although all these assumptions form the basis of modern financial management, the CAPM model considers other assumptions as well. The most important of all is the frictionless markets without stable conditions such as transaction cost, taxes and limitation on the extent to which you borrow. The model also considers the statistical nature of the stock return and investor preferences. Many researchers have dug further into the problem so as to soften these assumptions but they resulted in deriving more complications (Laubscher, 2002).
As Lawson & Pike (1979) narrated that CAPM deals with the risk and return of the stock and focuses on defining it perfectly. Even though investors buy any particular stock under the assumption of getting the expected return, the fluctuation in the market causes the result to move up and down