Measuring the company's cost of equity capital is a crucial responsibility of the corporate finance management. But calculating the cost of equity raises a lot of questions since the outcome is sometimes arbitrary and not always a solid yardstick. One extremely popular technique known as the capital asset pricing model can be used to simplify this procedure.
The Capital Asset Pricing Model (CAPM) explains the correlation between the anticipated return and the risk of investing in a security. It demonstrates that a security's anticipated return is equal to the risk-free return plus a risk premium that is calculated using the security's beta. The model offers a mechanism for estimating expected return on equity by evaluating risk and converting that risk into estimates.
The relation can be calculated using this CAPM formula-
The complete calculation accounts for the possible gains that an investor may realize given their propensity for taking calculated risks and their extended investment horizon. The beta component is seen as a risk in connection with the present market circumstances.
Expected dividend of investment = Risk-free rate + Beta factor of underlying transaction x Current market risk premium
Ra = Rf + Be (Rm- Rf)
The beta of a proposed investment is a measure of how much risk the investment will contribute to a portfolio that resembles the market. If the investment risk is lower then the existing market circumstances, the beta value will be less than one. On the other hand, beta value will always be 1 for risk equal to market circumstances. Consequently, the value will be larger than 1 if the risk exceeds the level of the market.
The market risk premium, or projected return from the market over the risk-free rate, is then multiplied by the beta of a stock. And in the next step, added to the risk-free rate. The outcome should provide an investor with the necessary return or discount rate that they may use to calculate the asset's worth.
Is CAPM the smartest way to calculate risk- return relation?
The foremost advantage of this approach is that all systematic risks related to an investment are taken into account by the beta component. The dividend discount model, another well-liked return prediction model, ignores the implications of these risks on returns. Because market risk is uncertain and unpredictable, investors cannot fully avoid it.
However, the major drawback in the way is that it is challenging to estimate beta. Investors must compute a beta value for the securities they are investing in using this return calculation approach. An exact beta value can be challenging and time-consuming to determine. The most common practice is to substitute a value for beta, which may speed up return computations but decreases their accuracy.
The CAPM method is nevertheless commonly employed in spite of these drawbacks since it is straightforward and makes comparing different investment options simple.