How is the Cost of Equity calculated using CAPM?

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CAPM is often used by accountants and financial analysts to derive the cost of shareholder’s equity. As a relation between systematic risk and expected return on assets, CAPM is often used as the pricing model for riskier securities. CAPM model generates expected returns for assets which are used to calculate the cost of equity.

How to Calculate the Cost of Equity

The CAPM formula needs only three pieces of information, namely the rate of return for the general market, the risk-free rate, and the beta value of the stock in question,

$$\mathrm{𝑅_{π‘Ž} = 𝑅_{rf} + [𝐡_{π‘Ž} × (𝑅_{π‘š} − 𝑅_{rf})]}$$

where −

  • $𝑅_{π‘Ž}$ =Cost of Equity
  • $𝑅_{rf}$ =Risk-Free Rate
  • $𝐡_{π‘Ž}$ =Beta
  • $𝑅_{π‘š}$ =Market Rate of Return

The rate of return is the return generated by the market that holds the company's stock. Generally, the long-term rate, instead of short-term return of the market, is taken as the market rate of return. The beta of the stock is the risk level of individual security in comparison to the broader market.

Usually, a beta of 1 indicates that the stock moves equivalently to the market ups and downs. A higher value of beta indicates more volatility of the market while a smaller one indicates a stable market.

The risk-free rate is referred to as the short-term, risk-free government bond’s rate of return. So, the common risk of losing value in the stock is usually zero.

The cost of equity is a measure included in the weighted average cost of capital (WACC), which is widely used to determine the total estimated cost of all capital under different financing plans under one umbrella to find the most cost-effective mix of debt and equity financing.

Difference between CAPM and WACC

There is a difference between CAPM and WACC although people often mistake the two to be one and the same. While the CAPM is a formula for calculating the cost of equity, the cost of equity is only a part of the equation for calculating the WACC. The WACC refers to the firm's cost of capital, which includes the cost of debt and the cost of equity.

Why CAPM is Used to Calculate the Cost of Equity

CAPM is a tried-and-tested method for estimating the cost of shareholder equity. The CAPM model shows the relationship between systematic risk and expected return for assets and is applicable to numerous accounting and financial contexts. CAPM is the most used method to find the cost of equity, as it considers all the rates of return under one umbrella to calculate the cost of equity.

raja
Published on 28-Oct-2021 12:10:59
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