Finance Quiz: Capm Limitations
20 questions · exam conditions
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Capm LimitationsQuestion 1 of 20

An analyst is evaluating two firms. Firm SmallCap has a market capitalization of $50 million and a beta of 1.2. Firm LargeCap has a market capitalization of $50 billion and also has a beta of 1.2. According to the CAPM, both firms should have the same expected return. However, empirical evidence has consistently shown that firms like SmallCap have historically earned higher returns than firms like LargeCap. This phenomenon is a limitation of CAPM because it suggests:

beta estimates for small-cap stocks are systematically biased upwards, overstating their true risk.
transaction costs for small-cap stocks are higher, and the excess return is merely compensation for these costs.
small-cap stocks have higher idiosyncratic risk, and investors are compensated for bearing this risk.
there is a priced systematic risk factor associated with firm size that is not captured by market beta.
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Finance Quiz

Finance Quiz: Capm Limitations

Practice Capm Limitations in Finance with focused quiz questions that help you check what you know, review explanations, and build confidence with test-style prompts.

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This quiz focuses on Capm Limitations, giving you a quick way to practice the rules, question types, and explanations that matter most for Finance.

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Try each quiz question before looking at the correct answer. Use the explanations to review missed ideas, then come back to similar questions until the pattern feels familiar.

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Question 1

An analyst is evaluating two firms. Firm SmallCap has a market capitalization of $50 million and a beta of 1.2. Firm LargeCap has a market capitalization of $50 billion and also has a beta of 1.2. According to the CAPM, both firms should have the same expected return. However, empirical evidence has consistently shown that firms like SmallCap have historically earned higher returns than firms like LargeCap. This phenomenon is a limitation of CAPM because it suggests:

  1. beta estimates for small-cap stocks are systematically biased upwards, overstating their true risk.
  2. transaction costs for small-cap stocks are higher, and the excess return is merely compensation for these costs.
  3. small-cap stocks have higher idiosyncratic risk, and investors are compensated for bearing this risk.
  4. there is a priced systematic risk factor associated with firm size that is not captured by market beta. (correct answer)
Explanation: This question tests your understanding of CAPM limitations and factor models in asset pricing. When you encounter scenarios where CAPM predictions don't match empirical evidence, you should think about what systematic risk factors might be missing from the model. The CAPM predicts that two stocks with identical betas should have the same expected return, regardless of firm size. However, decades of empirical research have documented the "small-firm effect" - smaller companies consistently generate higher risk-adjusted returns than larger companies with similar market betas. This anomaly suggests that firm size itself represents a priced risk factor that CAPM fails to capture. Answer D correctly identifies this limitation: there's a systematic risk factor related to firm size that market beta alone cannot explain. This discovery led to the development of multi-factor models like the Fama-French three-factor model, which includes a size factor (SMB - Small Minus Big) alongside market beta. Answer A is wrong because the issue isn't biased beta estimates - the betas are measured correctly, but beta alone is insufficient. Answer B incorrectly attributes the excess returns to transaction costs rather than systematic risk compensation; while small-cap stocks do have higher transaction costs, this doesn't explain risk-adjusted return differences. Answer C confuses idiosyncratic risk with systematic risk - investors aren't compensated for firm-specific (idiosyncratic) risk since it can be diversified away. Remember: when CAPM fails to explain return patterns, look for missing systematic risk factors rather than measurement errors or idiosyncratic explanations. Size, value, and momentum are the most well-documented additional factors.

Question 2

A key assumption of the CAPM is that all investors have homogeneous expectations. This means they agree on the expected returns, variances, and covariances of all assets. Which of the following market phenomena most directly challenges this assumption?

  1. The existence of index funds that passively track a broad market benchmark.
  2. The high trading volume observed in financial markets, even in the absence of major news. (correct answer)
  3. The tendency for stock prices to fall on the announcement of a corporate dividend cut.
  4. The persistence of a positive equity risk premium over long historical periods.
Explanation: If all investors had homogeneous expectations, they would all agree on the optimal risky portfolio (the market portfolio). In such a world, they would simply buy and hold their appropriate allocation to this portfolio. There would be little reason for active trading between investors, as no one would believe they have superior information or a different valuation. The observation of extremely high trading volume suggests that investors have heterogeneous (differing) beliefs about the future prospects and valuations of assets, leading them to trade with each other.

Question 3

According to Roll's Critique, the linear relationship between expected return and beta predicted by the CAPM is a tautology if the chosen market portfolio proxy is mean-variance efficient. This means that:

  1. any test of the CAPM using a mean-variance efficient proxy will, by mathematical necessity, support the model's predictions. (correct answer)
  2. the CAPM can only be considered valid if the market proxy used to test it is proven to be ex-post inefficient.
  3. beta is only a meaningful measure of risk if it is calculated relative to a mean-variance efficient portfolio.
  4. the CAPM's assumptions are so restrictive that the model can only hold true in a purely theoretical world.
Explanation: A key part of Roll's Critique is that the SML relationship is not unique to the 'true' market portfolio. Mathematically, a linear relationship between expected returns and betas will exist for any portfolio that is mean-variance efficient. Therefore, if an analyst chooses a market proxy (like the S&P 500) and finds that it was mean-variance efficient over the sample period, then finding a linear SML relationship is a mathematical certainty (a tautology). It doesn't prove that the S&P 500 is the true market portfolio or that the CAPM's economic theory is correct.

Question 4

In reality, investors typically borrow at a rate higher than the risk-free lending rate (e.g., the rate on T-bills). How does this real-world constraint most fundamentally affect the theoretical structure of the CAPM?

  1. It causes the Security Market Line (SML) to become downward sloping for assets with very high betas.
  2. It invalidates the concept of a single market portfolio being the optimal risky portfolio for all investors. (correct answer)
  3. It implies that beta is no longer a relevant measure of an asset's co-movement with the market.
  4. It suggests that idiosyncratic risk becomes a priced factor in determining expected returns.
Explanation: In the standard CAPM, all investors hold a combination of the risk-free asset and a single, unique optimal risky portfolio (the market portfolio). This arises from a linear Capital Allocation Line (CAL) that is tangent to the efficient frontier. When the borrowing rate is higher than the lending rate, the CAL becomes 'kinked.' As a result, highly risk-averse investors might hold a portfolio on the lending portion of the line, while highly risk-tolerant investors might hold a different risky portfolio on the borrowing portion. This means there is no longer a single optimal risky portfolio for everyone, challenging the universality of the market portfolio.

Question 5

An analyst observes two stocks, Firm A and Firm B, with identical CAPM betas. Firm A's stock is highly liquid, while Firm B's stock is illiquid and trades infrequently. The analyst finds that Firm B's stock has consistently delivered a higher average return than Firm A's stock. This finding suggests a limitation of the CAPM because:

  1. the beta for the illiquid stock, Firm B, is likely estimated with more error, thus invalidating the comparison.
  2. illiquidity appears to be a systematic risk factor for which investors demand a return premium, but it is not captured by market beta. (correct answer)
  3. rational investors would prefer the liquid stock, Firm A, causing its price to be bid up and its expected return to be lower.
  4. the CAPM assumes all information is publicly available, which is often not true for infrequently traded stocks like Firm B.
Explanation: The CAPM is a single-factor model where market beta is the only priced risk. The scenario describes two firms with the same beta but different returns. The systematic difference in returns can be attributed to the difference in liquidity. This implies that investors demand a higher expected return (a premium) for holding less liquid assets, as they face higher transaction costs and the risk of not being able to sell quickly at a fair price. Since this liquidity premium exists and is not explained by beta, it represents a priced risk factor that the CAPM fails to include.

Question 6

One of the most significant theoretical challenges to implementing the CAPM, as highlighted by Roll's Critique, is the unobservability of the true market portfolio. Which of the following assets represents the largest component of this theoretical market portfolio but is almost always excluded from the proxies used in practice (e.g., S&P 500, MSCI World)?

  1. Privately held corporate equity and debt.
  2. Global real estate, including residential and commercial property.
  3. Human capital, representing the present value of future labor income. (correct answer)
  4. Government bonds and other sovereign debt instruments.
Explanation: The true market portfolio should, in theory, include the value of all assets. While stocks, bonds, and real estate are enormous asset classes, the largest component of total wealth for most economies is human capital—the collective earning power of the workforce. This asset is non-tradable and its value is extremely difficult to measure, so it is always excluded from practical market portfolio proxies. This omission is a critical aspect of Roll's Critique, as the returns on financial assets may be significantly related to the returns on human capital.

Question 7

Arbitrage Pricing Theory (APT) offers an alternative to the CAPM. While both are equilibrium models, APT was developed in part to overcome a key limitation of the CAPM. Unlike CAPM, APT does not require:

  1. the assumption of rational, risk-averse investors who seek to maximize their utility.
  2. that idiosyncratic, firm-specific risk can be diversified away in a large portfolio.
  3. that the relationship between expected return and risk factors must be linear.
  4. the identification of a single, all-encompassing 'market portfolio' to measure systematic risk. (correct answer)
Explanation: When comparing asset pricing models, focus on their fundamental assumptions and requirements. Both CAPM and APT explain how risk factors influence expected returns, but they differ significantly in their structural requirements. APT's key advantage over CAPM is its flexibility in identifying risk factors. While CAPM requires you to identify and measure a single "market portfolio" that captures all systematic risk, APT allows multiple risk factors without specifying exactly what they are. This makes APT more practical since the theoretical market portfolio (containing every risky asset) is impossible to observe in reality. APT simply requires that returns follow a factor structure - it doesn't dictate which factors or how many. Looking at the incorrect options: Choice A is wrong because APT absolutely requires rational, utility-maximizing investors - this is fundamental to any equilibrium pricing model. Choice B is incorrect since APT, like CAPM, relies on diversification eliminating firm-specific risk so that only systematic factors matter for pricing. Choice C misses the mark because APT explicitly assumes linear relationships between expected returns and risk factors - this linearity is core to the model's mathematical structure. The correct answer is D because APT eliminates CAPM's problematic requirement of identifying the elusive market portfolio. Instead of one all-encompassing market factor, APT can work with observable factors like industrial production, inflation, or interest rates. Study tip: Remember APT as the "flexible" model - it keeps CAPM's core assumptions about investors and diversification but relaxes the restrictive requirement of finding the perfect market portfolio.

Question 8

The observation that many investors exhibit loss aversion, feeling the pain of a loss more strongly than the pleasure of an equivalent gain, and often hold on to losing investments too long, directly contradicts which core assumption of the CAPM?

  1. Investors have homogeneous expectations about asset returns, volatilities, and correlations.
  2. Asset markets are frictionless, with no taxes or transaction costs to impede trading.
  3. Investors are rational mean-variance optimizers who make decisions based solely on expected return and risk. (correct answer)
  4. All assets are infinitely divisible and can be bought or sold in any desired quantity.
Explanation: The CAPM is built on the foundation of modern portfolio theory, which assumes investors are rational and make decisions based purely on the mean (expected return) and variance (risk) of their portfolios. Behavioral biases like loss aversion show that investors' decisions are influenced by psychological factors beyond this simple trade-off. For example, loss aversion can lead to an irrational refusal to sell a losing stock, which is not a decision consistent with mean-variance optimization.

Question 9

The CAPM uses beta, which is derived from variance and covariance, as its sole measure of priced risk. A critique of this approach is that investors are primarily concerned with downside risk (losses) rather than overall volatility. If this critique is valid, which of the following would be a likely consequence?

  1. Two assets with the same beta would always have the same expected return, regardless of their return distributions.
  2. Idiosyncratic risk, especially the portion related to potential large losses, would become a priced factor.
  3. The market portfolio would no longer be considered the optimal risky portfolio for a rational investor.
  4. An asset with high upside potential but low downside risk might have a lower expected return than an asset with the same beta but significant downside risk. (correct answer)
Explanation: This question tests your understanding of CAPM's limitations and how alternative risk measures might affect asset pricing. The CAPM assumes investors care equally about upside and downside volatility, but if investors primarily fear losses, the pricing implications would be significant. If downside risk is what really matters to investors, then assets with the same beta but different downside characteristics should be priced differently. An asset with high upside potential but limited downside risk would be more attractive to loss-averse investors than an asset with the same beta but significant downside risk. Since the more attractive (lower downside risk) asset would face higher demand, its price would be bid up and its expected return would be lower. This makes choice D correct. Choice A is wrong because it describes CAPM's current prediction, not a consequence of the critique being valid. Choice B incorrectly suggests idiosyncratic risk would become priced - but even with downside focus, only systematic downside risk would be priced since idiosyncratic risk can still be diversified away. Choice C is incorrect because the market portfolio could still be optimal; the issue isn't with diversification benefits but with how we measure the relevant risk. When you encounter CAPM critique questions, focus on how alternative risk measures would change asset pricing relationships. The key insight is that if investors have asymmetric preferences about risk (caring more about losses than gains), assets with identical traditional risk measures but different loss profiles would command different prices in equilibrium.

Question 10

A central bank unexpectedly raises interest rates significantly to combat inflation. An analyst notes that following this event, the expected market risk premium likely increased, and the betas of highly leveraged firms also rose. This situation highlights which practical limitation of the CAPM?

  1. The model's parameters (risk-free rate, market risk premium, beta) are not stable over time and can shift with macroeconomic conditions. (correct answer)
  2. The model fails to account for inflation risk as a separate priced factor for which investors demand compensation.
  3. The model assumes investors are rational, whereas their risk aversion may change irrationally during periods of market stress.
  4. The model's reliance on a single risk-free asset is flawed when there are multiple points on the Treasury yield curve.
Explanation: The CAPM equation E[Ri]=Rf+βi(E[Rm]−Rf)E[R_i] = R_f + \beta_i(E[R_m] - R_f) is often applied as if its inputs are static. This scenario demonstrates that they are not. A change in central bank policy directly changes the risk-free rate (RfR_f). It also alters expectations about future economic growth and risk, changing the market risk premium (E[Rm]−RfE[R_m] - R_f). Furthermore, it can change the systematic risk (βi\beta_i) of individual firms, especially those sensitive to interest rates or leverage. This non-stationarity of all key parameters is a major challenge when using the model for valuation or forecasting.

Question 11

A researcher sorts all stocks in a market into deciles based on their book-to-market (B/M) ratios. They find that, after controlling for market beta, the portfolio of stocks with the highest B/M ratios consistently generates a positive alpha, while the portfolio with the lowest B/M ratios generates a negative alpha. This result is a well-known critique of CAPM, suggesting that:

  1. market beta is an unreliable measure of risk for companies with high levels of intangible assets.
  2. a factor related to relative firm value (value vs. growth) is a priced risk factor not captured by market beta. (correct answer)
  3. investors systematically overestimate the growth prospects of low B/M firms and underestimate those of high B/M firms.
  4. the CAPM only holds true for efficient markets, and this finding indicates severe market inefficiency.
Explanation: This empirical finding describes the 'value effect,' one of the key anomalies that the CAPM cannot explain. The fact that high book-to-market (value) stocks outperform low book-to-market (growth) stocks on a risk-adjusted basis (after accounting for beta) implies that the CAPM is incomplete. The most common interpretation is that the model is misspecified and is missing a systematic risk factor related to value/growth that the market prices. This finding was a primary motivation for the Fama-French three-factor model.

Question 12

A technology conglomerate, previously focused on enterprise software, has just completed a major acquisition of a large utility company. A portfolio manager, using a standard 60-month regression of the conglomerate's stock returns against the market, calculates a beta of 1.4. In using this beta to estimate the company's cost of equity via CAPM, the manager is most likely introducing an error because:

  1. the company's systematic risk profile has fundamentally changed, making the historical beta a poor indicator of future risk. (correct answer)
  2. the risk-free rate used in the CAPM calculation is likely to be unstable following such a large market event.
  3. the acquisition of a utility company will increase the conglomerate's specific risk, which is not captured by beta.
  4. a 60-month regression period is too long and over-smooths the beta estimate for a dynamic technology company.
Explanation: A primary limitation of CAPM in practice is the estimation of beta. Beta is estimated using historical data, which assumes the company's risk profile is stable. The acquisition of a utility (typically a low-beta, stable business) by a technology firm (typically a high-beta, growth business) represents a significant structural change. This change in business mix fundamentally alters the company's systematic risk, rendering the beta calculated from pre-acquisition historical data an unreliable forecast of its future systematic risk.

Question 13

An analyst is attempting to test the validity of the CAPM by regressing the historical excess returns of 100 individual stocks against the excess returns of a broad market index, the S&P 500. The analyst finds a statistically significant linear relationship for most stocks. According to Roll's Critique, what is the most significant limitation of this finding?

  1. The finding is invalid because the S&P 500 is not a globally diversified index and omits major asset classes.
  2. The test only demonstrates that the chosen market proxy (S&P 500) was mean-variance efficient during the sample period. (correct answer)
  3. The use of historical data to estimate betas cannot reliably predict future returns, making the CAPM test inherently flawed.
  4. The analyst should have used a multi-factor model since single-factor models are widely acknowledged to be incomplete.
Explanation: Roll's Critique argues that the CAPM is not testable because the true market portfolio is unobservable. Any test of the CAPM is actually a joint test of both the model and the efficiency of the chosen market proxy. A finding of a linear relationship between returns and beta calculated against a proxy (like the S&P 500) is a mathematical tautology if that proxy itself is mean-variance efficient. Therefore, the test doesn't validate CAPM in a general sense; it only shows that the chosen index was efficient.

Question 14

A financial consultant argues, "Even if we could perfectly identify and track the true global market portfolio of all assets, the CAPM would still be of limited practical use for estimating the cost of equity for an individual firm." Which of the following CAPM limitations provides the strongest support for this argument?

  1. The historical correlation between the firm and the true market portfolio is unstable and non-stationary over time. (correct answer)
  2. The assumption of a single-period investment horizon is unrealistic for long-term project valuation.
  3. Many investors are not rational mean-variance optimizers, leading to security mispricings.
  4. The existence of taxes and transaction costs would distort the Security Market Line relationship.
Explanation: The consultant's argument focuses on the practical application of the model for a single firm, even if the theoretical market portfolio problem were solved. The biggest remaining challenge would be estimating the firm's beta. Beta measures the co-movement of a firm's returns with the market. This relationship is not constant; it changes over time due to shifts in the firm's strategy, leverage, industry dynamics, and the broader economy. This non-stationarity makes it extremely difficult to use historical data to get a reliable estimate of the future beta, which is what is needed for cost of equity calculations.

Question 15

An empirical study of stock returns finds that a portfolio of the lowest-beta stocks earned an average return of 10%, while the market portfolio earned 12% and Treasury bills earned 3%. A portfolio of the highest-beta stocks earned 14%. Which limitation of the theoretical CAPM does this finding most directly challenge?

  1. The assumption that investors can borrow and lend unlimited amounts at a single risk-free rate.
  2. The prediction that expected returns are linearly and positively related to systematic risk with a specified slope. (correct answer)
  3. The use of a single-period investment horizon, which ignores reinvestment risk and changing opportunities.
  4. The definition of the market portfolio, which should include all investable assets, not just publicly traded stocks.
Explanation: This finding illustrates the 'low-beta anomaly' and the 'flat SML' phenomenon. The theoretical SML predicts a steeper relationship. For example, if the low-beta portfolio had a beta of 0.5, CAPM would predict a return of 3%+0.5×(12%−3%)=7.5%3\% + 0.5 \times (12\% - 3\%) = 7.5\%. The actual return was 10%. If the high-beta portfolio had a beta of 1.5, CAPM would predict 3%+1.5×(12%−3%)=16.5%3\% + 1.5 \times (12\% - 3\%) = 16.5\%. The actual return was 14%. Low-beta stocks earned more than predicted, and high-beta stocks earned less. This contradicts the predicted linear relationship and slope of the SML.

Question 16

Numerous empirical studies have found that the actual relationship between average historical returns and beta is 'flatter' than the theoretical Security Market Line (SML) predicted by CAPM. What does this 'flatter' SML imply?

  1. The true risk-free rate is substantially higher than the rate on government securities.
  2. High-beta stocks have, on average, earned lower returns than predicted by CAPM, and low-beta stocks have earned higher returns. (correct answer)
  3. The market risk premium has been, on average, negative over long periods, which contradicts CAPM's assumptions.
  4. Beta is a poor measure of risk, and a measure of total volatility (standard deviation) would be a better predictor of returns.
Explanation: The theoretical SML starts at the risk-free rate (RfR_f) and has a slope equal to the market risk premium (E[Rm]−RfE[R_m] - R_f). An empirical SML that is 'flatter' means it has a higher intercept (starting point) and a lower slope than the theoretical SML. Because of the higher intercept and lower slope, the empirical line lies above the theoretical SML for low-beta stocks (meaning they earned more than predicted) and below the theoretical SML for high-beta stocks (meaning they earned less than predicted).

Question 17

A portfolio manager constructs a 'winners' portfolio of stocks that had the highest returns over the past 12 months and a 'losers' portfolio of stocks with the lowest returns. They find that, over the subsequent 3 months, the winners portfolio significantly outperforms the losers portfolio, even after adjusting for the CAPM betas of both portfolios. This result highlights which empirical failure of the CAPM?

  1. The value effect, where stocks with low market-to-book ratios outperform.
  2. The instability of beta, as the betas of the winning and losing stocks likely changed over the period.
  3. The momentum effect, suggesting that recent price trends are a priced characteristic not explained by market risk. (correct answer)
  4. The low-volatility anomaly, where less risky stocks provide higher risk-adjusted returns.
Explanation: This strategy of buying recent winners and selling recent losers is the basis for the 'momentum' anomaly. The finding that this strategy generates alpha (excess returns after adjusting for CAPM beta) indicates that CAPM is failing to capture a priced factor. The momentum effect suggests that information is not incorporated into prices instantaneously and that short-term trends persist. Because market beta does not account for this phenomenon, it represents a significant empirical critique of the model.

Question 18

The Zero-Beta CAPM was developed by Fischer Black to address a specific limitation of the original Sharpe-Lintner CAPM. This version of the model replaces the risk-free rate in the SML equation with the expected return on the 'zero-beta portfolio.' The development of this alternative model was primarily motivated by the critique that:

  1. the true market portfolio is unobservable in practice.
  2. investor expectations about asset returns are heterogeneous, not homogeneous.
  3. beta is an insufficient measure of risk, and other factors like size and value are needed.
  4. investors' borrowing rates are typically higher than their lending rates. (correct answer)
Explanation: When you encounter questions about CAPM model variations, focus on understanding what specific real-world problem each version was designed to solve. The Zero-Beta CAPM addresses a practical constraint that makes the original model difficult to implement. The original Sharpe-Lintner CAPM assumes investors can borrow and lend unlimited amounts at the same risk-free rate. Fischer Black recognized this was unrealistic because in practice, investors face different borrowing and lending rates - you can lend money (invest in Treasury bills) at a relatively low rate, but borrowing money costs significantly more due to credit risk premiums and transaction costs. This asymmetry creates a "kinked" capital allocation line rather than the straight line assumed in the original model. Black's solution was elegant: replace the risk-free rate with the expected return on a "zero-beta portfolio" - a portfolio that has zero correlation with the market but isn't necessarily risk-free. This modification preserves the model's mathematical structure while eliminating the unrealistic borrowing assumption. Option A refers to Roll's critique about market portfolio observability, which is a different limitation entirely. Option B describes heterogeneous expectations, which relates to other CAPM extensions but wasn't Black's primary concern. Option C points to multi-factor models like Fama-French, which address the inadequacy of beta as a single risk measure - again, not the Zero-Beta CAPM's focus. Remember this pattern: when studying asset pricing models, each major variation typically addresses one specific unrealistic assumption from the original framework. Identifying which assumption is being relaxed helps you understand the model's purpose.

Question 19

In reality, investors typically borrow at a rate higher than the risk-free lending rate (e.g., the rate on T-bills). How does this real-world constraint most fundamentally affect the theoretical structure of the CAPM?

  1. It causes the Security Market Line (SML) to become downward sloping for assets with very high betas.
  2. It invalidates the concept of a single market portfolio being the optimal risky portfolio for all investors. (correct answer)
  3. It implies that beta is no longer a relevant measure of an asset's co-movement with the market.
  4. It suggests that idiosyncratic risk becomes a priced factor in determining expected returns.
Explanation: In the standard CAPM, all investors hold a combination of the risk-free asset and a single, unique optimal risky portfolio (the market portfolio). This arises from a linear Capital Allocation Line (CAL) that is tangent to the efficient frontier. When the borrowing rate is higher than the lending rate, the CAL becomes 'kinked.' As a result, highly risk-averse investors might hold a portfolio on the lending portion of the line, while highly risk-tolerant investors might hold a different risky portfolio on the borrowing portion. This means there is no longer a single optimal risky portfolio for everyone, challenging the universality of the market portfolio.

Question 20

A technology conglomerate, previously focused on enterprise software, has just completed a major acquisition of a large utility company. A portfolio manager, using a standard 60-month regression of the conglomerate's stock returns against the market, calculates a beta of 1.4. In using this beta to estimate the company's cost of equity via CAPM, the manager is most likely introducing an error because:

  1. the company's systematic risk profile has fundamentally changed, making the historical beta a poor indicator of future risk. (correct answer)
  2. the risk-free rate used in the CAPM calculation is likely to be unstable following such a large market event.
  3. the acquisition of a utility company will increase the conglomerate's specific risk, which is not captured by beta.
  4. a 60-month regression period is too long and over-smooths the beta estimate for a dynamic technology company.
Explanation: A primary limitation of CAPM in practice is the estimation of beta. Beta is estimated using historical data, which assumes the company's risk profile is stable. The acquisition of a utility (typically a low-beta, stable business) by a technology firm (typically a high-beta, growth business) represents a significant structural change. This change in business mix fundamentally alters the company's systematic risk, rendering the beta calculated from pre-acquisition historical data an unreliable forecast of its future systematic risk.