Capital Asset Pricing Model



1
What is Capital Asset Pricing Model and explain with example

2 Answer(s)


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CAPM is used to determine an appropriate rate of return for a security/company/investment etc. In DCF valuation CAPM is used to determine the cost of equity.

The formula is Ra=Rf+Beta*(Rm-Rf), were Ra is cost of equity, Rf is the risk free rate, and Rm is the excess market premium.

The whole idea is you want to find out - if the company is raising equity from the market, then what will be the cost of that equity. The logic is the cost of equity for the company is definitely more than the "risk free rate" that is used for government bonds etc. To find out how much more we use (Rm-Rf) which indicates what the general stock market returns are.

This is multiplied with Beta to sensitize the stock market returns to this company's particular stock performance.


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Assume you have to find the cost of equity for Facebook.

Assume that Rf or the risk free rate (of american government bonds) = 3%
Assume that the market returns / Rm is 9%
So Rm-Rf = 6%
Assume beta is 0.8

So Facebooks cast of equity will be 3+0.8*6 = 7.8%

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