This lesson examines the Capital Asset Pricing Model as the primary method for estimating the cost of equity. It covers the model’s components, assumptions, and practical application.

• The CAPM Framework: The Capital Asset Pricing Model describes the relationship between systematic risk and expected return for assets, particularly stocks. It is widely used to estimate the cost of equity capital for a firm. The University of Greenwich module identifies CAPM as a key topic alongside the cost of capital and investment project evaluation.

• The CAPM Formula: The expected return on a security (or the cost of equity) is calculated as:

  • E(Ri) = Rf + βi × (E(Rm) – Rf)

  • Rf = Risk-free rate (typically the yield on long-term government bonds)

  • βi = Beta, a measure of the stock’s systematic risk relative to the market

  • E(Rm) – Rf = Market risk premium (the expected return on the market minus the risk-free rate)

• Components of the CAPM:

  • Risk-Free Rate: The rate of return on a risk-free asset, usually government securities. The current yield on long-term Treasury bonds is a common proxy.

  • Beta: A measure of the stock’s volatility relative to the market. A beta of 1 indicates the stock moves with the market; a beta greater than 1 is more volatile; a beta less than 1 is less volatile.

  • Market Risk Premium: The premium investors demand for investing in the market portfolio instead of risk-free assets.

• Limitations of the CAPM: The CAPM relies on strong assumptions about market efficiency and investor behavior. Estimating beta and the market risk premium is subject to uncertainty. Despite these limitations, the CAPM is a widely accepted and practical method for estimating the cost of equity.

• Other Methods for Estimating Cost of Equity: Beyond CAPM, the Dividend Discount Model (DDM) and the Earnings Capitalization Ratio method can be used to estimate the cost of equity.