Lesson 5: Risk, Return, and the Cost of Capital

This lesson examines the relationship between risk and return and its application to the cost of capital.

5.1 Risk and Return Fundamentals

Investors require higher returns for bearing higher risk . The Capital Asset Pricing Model (CAPM) quantifies this relationship: the expected return on an asset is a function of the risk-free rate plus a risk premium based on the asset’s systematic risk (beta) . Systematic risk is the risk inherent in the entire market.

5.2 The Cost of Capital

The cost of capital is the minimum return a company must earn on its investments to satisfy its investors . It reflects the opportunity cost of capital—the return investors could earn elsewhere at a similar level of risk. The Weighted Average Cost of Capital (WACC) is a weighted average of the cost of debt and the cost of equity . The cost of debt is the required rate on debt, adjusted for tax deductibility. The cost of equity is estimated using the CAPM.