Question

In at least 200 words, what is Capital Asset Pricing Model (CAPM), how and why is it used. and why is it important?

Answer 1

Cost of equity is the required rate of return on the company’s common stock. The cost of equity is calculated using the Capital Asset Pricing Model (CAPM). It helps to understand the return expected by investors in the business.

It is calculated using the formula below:

Ke=Rf+[E(Rm)-Rf]

where:

Rf=risk-free rate of return

Rm=expected rate of return on the market.

= stock’s beta

CAPM definitely has value to understand the return expected by investors in the business. The security market line is a graphical representation of the CAPM formula. It plots the relationship between the expected return and beta associated with a security. If a security’s expected return is plotted above the SML, the security is undervalued and if it is plotted below the line, the security is overvalued.

Importance of CAPM:

It determines the fair price for an investment, based on the risk, potential return and other factors. CAPM provides a good understanding of the risk versus return on an investment. It is great tool to use when determining whether riskier assets are worth the investment. CAPM is considered a much better model of calculating the cost of equity as against the dividend discount model.

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