How to use the CAPM (capital asset pricing model) to determine cost of equity?

Modified on Thu, 05 Jul 2018 at 04:56 PM

In capital budgeting, corporate accountants and finance analysts often use the capital asset pricing model, or CAPM, to estimate the cost of shareholder equity. CAPM describes the relationship between systematic risk and expected return for assets. It is widely used for the pricing of risky securities, generating expected returns for assets given the associated risk and calculating costs of capital.

Determining the Cost of Equity with CAPM

The CAPM formula requires only three pieces of information: the rate of return for the general market, the beta value of the stock in question and the risk-free rate.

Cost of Equity = Risk-Free Rate + Beta * (Market Rate of Return - Risk-Free Rate)

The rate of return refers to the returns generated by the market in which the company's stock is traded. If company CBW trades on the Nasdaq and the Nasdaq has a return rate of 12 percent, this is the rate used in the CAPM formula to determine the cost of CBW's equity financing.

The beta of the stock refers to the risk level of the individual security relative to the wider marker. A beta value of 1 indicates the stock moves in tandem with the market. If the Nasdaq gains 5 percent, so does the individual security. A higher beta indicates a more volatile stock and a lower beta reflects greater stability.

Source : Investopedia

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