What is the CAPM approach to estimating a business's cost of equity? How does this relate...

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Finance

What is the CAPM approach to estimating a business's cost ofequity? How does this relate to financial management? Explain whythere is uncertainty in this model.

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No matter how much you diversify your investments some level ofrisk will always exist So investors naturally seek a rate ofreturn that compensates for that risk The capital asset pricingmodel CAPM helps to calculate investment risk and what return oninvestment an investor should expectSystematic Risk vs Unsystematic RiskThe capital asset pricing model was developed by the financialeconomist and later Nobel laureate in economics William Sharpeset out in his 1970 book Portfolio Theory and CapitalMarkets His model starts with the idea that individualinvestment contains two types of riskSystematic Risk These are market risksthat isgeneral perils of investingthat cannot be diversified awayInterest rates recessions and wars are examples of systematicrisksUnsystematic Risk Also known as specific riskthis risk relates to individual stocks In more technical terms itrepresents the component of a stocks return that is not correlatedwith general market movesModern portfolio theory shows that specific risk can be removedor at least mitigated through diversification of a portfolio Thetrouble is that diversification still does not solve the problem ofsystematic risk even a portfolio holding all the shares in thestock market cant eliminate that risk Therefore when calculatinga deserved return systematic risk is what most plaguesinvestorsThe CAPM FormulaCAPM evolved as a way to measure this systematic risk Sharpefound that the return on an individual stock or a portfolio ofstocks should equal its cost of capital The standard formularemains the CAPM which describes the relationship between risk andexpected returnHere is the formulaeginaligned Ra Rrf etaa leftRm Rrfight extbfwhere Ra extExpected returnon a security Rrf extRiskfree rate Rm extExpected return of the market etaa extThebeta of the security leftRm Rrf ight extEquity market premiumendalignedRaRrfaRmRrfwhereRaExpected return on asecurityRrfRiskfree rateRmExpected return of the marketaThebeta of the securityRmRrfEquity market premiumCAPMs starting point is the riskfree ratetypically a 10yeargovernment bond yield A premium is added one that equityinvestors demand as compensation for the extra risk they accrueThis equity market premium consists of the expected return from themarket as a whole less the riskfree rate of return The equityrisk premium is multiplied by a coefficient that Sharpe calledbetaBetas Role in CAPMAccording to CAPM beta is the only relevant measure of astocks risk It measures a stocks relative volatilitythat is itshows how much the price of a particular stock jumps up and downcompared with how much the entire stock market jumps up and downIf a share price moves exactly in line with the market then thestocks beta is 1 A stock with a beta of 15 would rise by 15 ifthe market rose by 10 and fall by 15 if the market fell by10Beta is found by statistical analysis of individual daily shareprice returns in comparison with the markets daily returns overprecisely the same period In their classic 1972 study The CapitalAsset Pricing Model Some Empirical Tests financial economistsFischer Black Michael C Jensen and Myron Scholes confirmed alinear relationship between the financial returns of stockportfolios and their betas They studied the price movements of thestocks on the New York Stock Exchange between 1931 and 1965Beta compared with the equity risk premium shows the amount ofcompensation equity investors need for taking on additional riskIf the stocks beta is 20 the riskfree rate is 3 and themarket rate of return is 7 the markets excess return is 4 7 3 Accordingly the stocks excess return is 8 2 x 4multiplying market return by the beta and the stocks totalrequired return is 11 8 3 the stocks excess return plus theriskfree rateWhat the beta calculation shows is See Answer

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