The Capital Asset Pricing Model (CAPM) is a financial model that is used to determine the expected return on an investment based on its risk level. The CAPM can be used to determine the cost of equity, which is the return that an investor expects to receive on an equity investment, such as a stock.
Here’s how to use the CAPM to determine the cost of equity:
- Determine the risk-free rate: The risk-free rate is the return that an investor expects to receive on an investment with zero risk. The risk-free rate is typically the yield on a long-term U.S. Treasury bond.
- Determine the beta: Beta is a measure of an investment’s volatility relative to the overall market. A beta of 1 means that an investment is as volatile as the market, while a beta greater than 1 means that an investment is more volatile than the market, and a beta less than 1 means that an investment is less volatile than the market.
- Determine the expected market return: The expected market return is the return that an investor expects to receive on the market as a whole. The expected market return can be calculated by using the historical return of the market or by using the expected future return of the market.
- Calculate the cost of equity: The cost of equity can be calculated using the following formula:
Cost of Equity = Risk-Free Rate + Beta x (Expected Market Return – Risk-Free Rate)
For example, if the risk-free rate is 2%, the beta of an investment is 1.5, and the expected market return is 8%, the cost of equity would be 12% (2% + 1.5 x (8% – 2%)).
By understanding the CAPM and how to use it to determine the cost of equity, investors can make more informed decisions about the expected return on their investments. It’s always a good idea to consult with a financial professional before making any investment decisions.