• Economics , Finance ,
• 15 Apr

Capital Asset Pricing Model is used to determine an appropriate expected rate of return of an asset based on the systemic risk of that asset. It says that given a certain amount of general risk, we should expect a certain amount of return on a security. Return on investment can also be called cost of equity. Cost of equity is an essential part of calculating the weighted average cost of capital (WACC).

The expected return of a security is equal to the risk free rate plus the risk premium in proportion to the amount of systemic risk in the investment. 

where

= Cost of Equity

= Risk free rate of return

= Beta of the Security

= Expected market rate of return

Let’s break it down

Essentially we are adding the risk free rate and the equity risk premium. This is also called the market risk premium or the expected market rate of return and is the market return in excess of a risk free investment that is weighted using beta.

Risk Free Rate

We suggest that you go straight to the source. Treasury.gov has yield curve rates. Typically we use 10 year, but Investopedia states the 3 month T-bill being acceptable. Some argue that a 10 year or 30 year bond cannot adjust to inflation the way a 3 month can. It really depends on the time horizon in question. If you include this in your assumptions and explain why, it helps support your results.

Expected Market Rate of Return

This is the expected return and is usually based on an index. This index can range from a portfolio customized for certain risk and investment style all the way to the S&P 500. You can expect a percentage of return in a portfolio that has removed all company specific risk. You may want to use the average excess return of the S&P 500. Again, it’s a good idea to list out your assumptions and to qualify them.

Beta

You can calculate beta manually, or look it up on Yahoo finance or Google finance. For the sake of learning, using publicly available beta’s are a great place to start. You can enter the ticker symbol on either one of these websites to pull up information about the security including it’s beta. For instance, Costco’s ticker symbol is COST.

Conclusion

CAPM does have it’s critics but is still widely used especially when it comes to calculating WACC.  It is still the main method many major corporations use to determine the equity cost of capital. It is one of the most important models that show the relationship of risk and return. William Sharpe received The Nobel Prize in Economics in 1990 along with Harry Markowitz and Merton Miller for developing this model.