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Hurdle Rate = Risk-Free Rate + Risk Premium

Beta of a security or a portfolio helps in analyzing the volatility or systematic risk of the particular stock or portfolio in relation to the market as a whole. The value of the Beta is used in The Capital Asset Pricing Model (CAPM).

The CAPM is a model which helps in understanding the relationship between the expected return and risk of a security or a portfolio and thus helps in the pricing of the security. The basic premise on which the CAPM is based is that an investor who is sacrificing his consumption in order to invest should be compensated for two things; one is the Time Value of Money and the risk which is inherent in the stock or the portfolio. The formula used to calculate the expected returns is:

RS = Rf + (Rm – Rf)*Beta

Now if we break the formula into two halves then we can say that the investor is being rewarded for Time Value of Money with the risk-free rate (Rf). The other half of the formula is known as the risk premium and tells us the portion of return which the investor needs for taking additional risk. The CAPM thus helps us to find out an expected return on a stock or a portfolio and then the expected rate of return is compared to the required rate of return and if the expected rate of return is greater than the required rate of return then the investment should be undertaken and if the expected return is less than the required rate of return then the investment should not be undertaken.

The CAPM model has a number of limitations: 1) Unrealistic Assumptions: The assumptions which are used in CAPM are unrealistic. The first assumption is finding a risk-free security which is next to impossible as even the real…...

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