Capital asset pricing model: Difference between revisions
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''Valuation and cost of capital''. | |||
(CAPM). | (CAPM). | ||
The capital asset pricing model links the expected rates of return on traded assets with their relative levels of market risk (beta). | The capital asset pricing model links the expected rates of return on traded assets with their relative levels of market risk (beta). | ||
The CAPM assumes a straight-line relationship between the beta of a traded asset and the | The model’s uses include estimating a firm’s market cost of equity from its beta and the market risk-free rate of return. | ||
The CAPM assumes a straight-line relationship between the beta of a traded asset and its expected rate of return. | |||
The model assumes that investors expect a return equal to the theoretically risk-free rate of return, plus a premium for the degree of risk accepted. | |||
__TOC__ | |||
==CAPM calculation== | |||
Expressed as a formula: | Expressed as a formula: | ||
Re = Rf + beta x (Rm - Rf) | |||
Rj = Rf + beta x (Rm - Rf) | |||
Where: | Where: | ||
Re = return on equity. | |||
Rf = theoretical [[risk free rate of return]]. | Rj = return on any traded risky asset | ||
Rf = theoretical [[risk-free rate of return]]. | |||
Beta = relative market risk. | Beta = relative market risk. | ||
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<span style="color:#4B0082">'''Example'''</span> | |||
Rf = theoretical risk free rate of return = 4% | Rf = theoretical risk free rate of return = 4%. | ||
Beta = relative market risk = 1.2 | Beta = relative market risk = 1.2. | ||
Rm = average expected rate of return on the market = 9%. | Rm = average expected rate of return on the market = 9%. | ||
Return on equity (Re): | |||
= | = 4 + 1.2 x (9 - 4) | ||
This investment requires an expected <u>rate of return</u> of 10%, higher than average rate of return on the market as a whole of only 9%, because its market <u>risk</u> (measured by | = 10%. | ||
This equity investment requires an expected <u>rate of return</u> of 10%, higher than average rate of return on the market as a whole of only 9%, because its market <u>risk</u> (measured by beta = 1.2) is greater than the average market risk (of only 1.0). | |||
Under the capital asset pricing model only the (undiversifiable) market risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all specific risk within their investment portfolios. | Under the capital asset pricing model only the (undiversifiable) market risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all specific risk within their investment portfolios. | ||
== Use of the CAPM to quantify cost of equity == | |||
When the CAPM is used to calculate an estimate of the cost of equity, it is conventionally expressed as: | |||
Ke = Rf + beta x (Rm - Rf) | |||
Where: | |||
Ke = cost of equity | |||
(& other terms are defined as above) | |||
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* [[Beta]] | * [[Beta]] | ||
* [[Business risk]] | * [[Business risk]] | ||
* [[Capital ]] | |||
* [[Capital gain]] | * [[Capital gain]] | ||
* [[Cost of equity]] | * [[Cost of equity]] | ||
* [[Dividend growth model]] | |||
* [[Equity beta]] | * [[Equity beta]] | ||
* [[Equity risk]] | * [[Equity risk]] | ||
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* [[Market risk]] | * [[Market risk]] | ||
* [[Market risk premium]] | * [[Market risk premium]] | ||
* [[Model]] | |||
* [[Modern Portfolio Theory]] | * [[Modern Portfolio Theory]] | ||
* [[Risk]] | * [[Risk]] | ||
* [[Risk-free rate of return]] | |||
* [[Security Market Line]] | |||
* [[Specific risk]] | * [[Specific risk]] | ||
* [[Systematic risk]] | * [[Systematic risk]] | ||
[[Category:Corporate_finance]] | |||
Latest revision as of 21:04, 4 July 2022
Valuation and cost of capital.
(CAPM).
The capital asset pricing model links the expected rates of return on traded assets with their relative levels of market risk (beta).
The model’s uses include estimating a firm’s market cost of equity from its beta and the market risk-free rate of return.
The CAPM assumes a straight-line relationship between the beta of a traded asset and its expected rate of return.
The model assumes that investors expect a return equal to the theoretically risk-free rate of return, plus a premium for the degree of risk accepted.
CAPM calculation
Expressed as a formula:
Re = Rf + beta x (Rm - Rf)
Rj = Rf + beta x (Rm - Rf)
Where:
Re = return on equity.
Rj = return on any traded risky asset
Rf = theoretical risk-free rate of return.
Beta = relative market risk.
Rm = average expected rate of return on the market.
Example
Rf = theoretical risk free rate of return = 4%.
Beta = relative market risk = 1.2.
Rm = average expected rate of return on the market = 9%.
Return on equity (Re):
= 4 + 1.2 x (9 - 4)
= 10%.
This equity investment requires an expected rate of return of 10%, higher than average rate of return on the market as a whole of only 9%, because its market risk (measured by beta = 1.2) is greater than the average market risk (of only 1.0).
Under the capital asset pricing model only the (undiversifiable) market risk of securities is rewarded with additional returns, because the model assumes that rational market participants have all fully diversified away all specific risk within their investment portfolios.
Use of the CAPM to quantify cost of equity
When the CAPM is used to calculate an estimate of the cost of equity, it is conventionally expressed as:
Ke = Rf + beta x (Rm - Rf)
Where:
Ke = cost of equity
(& other terms are defined as above)
