What Is the Capital Asset Pricing Model (CAPM)?
Corporate accountants and financial analysts often use the capital asset pricing model (CAPM) in capital budgeting to estimate the cost of shareholder equity. Described as the relationship between systematic risk and expected return for assets, CAPM is widely used for the pricing of risky securities, generating expected returns for assets given the associated risk, and calculating costs of capital.
Key Takeaways
- The capital asset pricing model (CAPM) is used to calculate expected returns given the cost of capital and risk of assets.
- The CAPM formula requires the rate of return for the general market, the beta value of the stock, and the risk-free rate.
- The weighted average cost of capital (WACC) is calculated with the firm’s cost of debt and cost of equity—which can be calculated via the CAPM.
- There are limitations to the CAPM, such as agreeing on the rate of return and which one to use and making various assumptions.
- There are online calculators for determining the cost of equity, but calculating the formula by hand or by using Excel is a relatively simple exercise.
Cost of Equity CAPM Formula
The CAPM formula requires only the following 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.
CAPM Formula
Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-Free Rate of Return)
The risk-free rate of return is the theoretical return of an investment that has zero risk. It’s considered theoretical because every investment carries some amount of risk, however small. It generally assumes the rate of return that’s offered by short-term government debt.
What the CAPM Can Tell You
The cost of equity is an integral part of the weighted average cost of capital (WACC). WACC is widely used to determine the total anticipated cost of all capital under different financing plans. WACC is often used to find the most cost-effective mix of debt and equity financing.
Assume Company ABC trades on the S&P 500 with a rate of return of 10%. The company’s stock is slightly more volatile than the market with a beta of 1.2. The risk-free rate based on the three-month T-bill is 4.5%.
Based on this information, the cost of the company’s equity financing is 11%: Cost of Equity = 4.5% + (1.2 * (10% – 4.5%)).
Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by hand or by using Microsoft Excel is a relatively simple exercise.
CAPM and Beta
Beta is one of the important features of CAPM, so let’s spend a minute specifically on that measurement. Beta tracks a stock’s volatility relative to the overall market. It indicates how much a stock’s price is expected to move in terms of market movements.
If a stock has a beta of 1, it tends to move in line with the market; a beta greater than 1 means the stock is more volatile than the market, while a beta less than 1 indicates it’s less volatile. If a stock has a beta of 1.5, it’s expected to be 50% more volatile than the market, moving up or down more sharply when the market changes.
In CAPM, beta is used to determine the expected return of an asset factoring in its risk relative to the market. CAPM assumes that investors need to be compensated for both the time value of money through the risk-free rate and the risk they take (through the market risk premium multiplied by beta). A higher beta increases the expected return, reflecting the higher risk associated with more volatile stocks.
The Difference Between CAPM and WACC
The CAPM is a formula for calculating the cost of equity. The cost of equity is part of the equation used for calculating the WACC. The WACC is the firm’s cost of capital. This includes the cost of equity and the cost of debt.
WACC Formula
WACC = [Cost of Equity * Percent of Firm’s Capital in Equity] + [Cost of Debt * Percent of Firm’s Capital in Debt * (1 – Tax Rate)]
WACC can be used as a hurdle rate against which to evaluate future funding sources. WACC can be used to discount cash flows with capital projects to determine net present value. A company’s WACC will be higher if its stock is volatile or seen as riskier as investors will demand greater returns to compensate for additional risk.
Limitations of Using CAPM
There are some limitations to the CAPM, such as agreeing on the rate of return and which one to use. Beyond that, there’s also the market return, which assumes positive returns, while also using historical data. This includes the beta, which is only available for publicly traded companies. The beta also only calculates systematic risk, which doesn’t account for the risk companies face in various markets.
Various assumptions must be made including that investors can borrow money without limitations at the risk-free rate. The CAPM also assumes that no transaction fees occur, investors own a portfolio of assets, and investors are only interested in the rate of return for a single period—all of which are not always true.
Why Does Cost of Equity Matter?
Let’s wrap up this article by talking about why the cost of equity matters. The cost of equity represents the return that investors expect in exchange for owning a company’s stock. Compared to safer investments, investors demand a higher return which is quantified as the cost of equity.
For businesses, understanding the cost of equity is key to making informed financial decisions. Before pursuing new projects or expansions, companies need to make sure the expected returns will exceed the cost of equity. If a project’s return is lower than the cost of equity, it could diminish shareholder value rather than enhance it. This is because the ultimate cost of undertaking a project and financing it through stock may be higher than the return the company receives from the investment.
Whether through optimizing their capital structure, improving their risk profile, or choosing projects that promise strong returns, companies need to understand and control their cost of equity. By understanding its cost of equity, a company can make better financing decisions. For instance, a company may decide it will be cheaper to take out more debt than it would be to issue more stock.
Is CAPM the Same As Cost of Equity?
CAPM is a formula used to calculate the cost of equity—the rate of return a company pays to equity investors. For companies that pay dividends, the dividend capitalization model can be used to calculate the cost of equity.
How Do You Calculate Cost of Equity Using CAPM?
The CAPM formula can be used to calculate the cost of equity, where the formula used is: Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return – Risk-Free Rate of Return).
What Are Some Potential Problems When Estimating the Cost of Equity?
The biggest issues when estimating the cost of equity include measuring the market risk premium, finding appropriate beta information, and using short- or long-term rates for the risk-free rate.
How Are CAPM and WACC Related?
WACC is the total cost of all capital. CAPM is used to determine the estimated cost of shareholder equity. The cost of equity calculated from the CAPM can be added to the cost of debt to calculate the WACC.
The Bottom Line
For accountants and analysts, CAPM is a tried-and-true methodology for estimating the cost of shareholder equity. The model quantifies the relationship between systematic risk and expected return for assets and applies to a multitude of accounting and financial contexts.
Read the original article on Investopedia.