1. Capital Asset Pricing Model
The CAPM is made up of three primary components.
The Risk free Rate, the CAPM assumes there is a risk free rate
of return. This is normally the yield on a long term government bond
from a highly rated economy. It is considered risk free
because it is free from default risk. Since it's risk free,
the required rate of return will be lower than risky investments.
Because a company is riskier than a risk free asset, we need to
add some premium to the risk free rate.
This premium is typically comprised of two components, the first being Beta.
Beta is the output of a statistical regression.
It measures a stock's return versus the return of the overall stock market.
It is the only company specific measure in the CAPM. The final component
of the CAPM is the Equity Risk Premium,
also known as the Market Risk Premium. This is the return of the
stock market over and above the risk free rate.
Historically, this usually falls between 4% and 8%.
So, to calculate the cost of equity using the CAPM we add the
risk free rate to Beta times the Equity Risk Premium.
2. Let's practice!