The Capital Asset Pricing Model - : The Cost of Equity
The Capital Asset Pricing Model - : The Cost of Equity
The Capital Asset Pricing Model - : The Cost of Equity
Whenever an investment is made, for example in the shares of a company listed on a stock market, there is a risk that the actual return on the
investment will be different from the expected return. Investors take the risk of an investment into account when deciding on the return they wish
to receive for making the investment. The CAPM is a method of calculating the return required on an investment, based on an assessment of
its risk.
There is a limit to this risk reduction effect, however, so that even a ‘fully diversified’ portfolio will not eliminate risk entirely. The risk which
cannot be eliminated by portfolio diversification is called ‘undiversifiable risk’ or ‘systematic risk’, since it is the risk that is associated with the
financial system. The risk which can be eliminated by portfolio diversification is called ‘diversifiable risk’, ‘unsystematic risk’, or ‘specific risk’,
since it is the risk that is associated with individual companies and the shares they have issued. The sum of systematic risk and unsystematic
risk is called total risk (Watson D and Head A, Corporate Finance: Principles and Practice, 7th edition, Pearson Education Limited, Harlow
pp.245-6).
investment based on its systematic risk alone, rather than on its total risk. The measure of risk used in the CAPM, which is called ‘beta’, is
therefore a measure of systematic risk.
The minimum level of return required by investors occurs when the actual return is the same as the expected return, so that there is no risk of
the investment's return being different from the expected return. This minimum level of return is called the ‘risk-free rate of return’.
The formula for the CAPM, which is included in the formulae sheet, is as follows:
This formula expresses the required return on a financial asset as the sum of the risk-free rate of return and a risk premium – βi (E(rm) – Rf) –
which compensates the investor for the systematic risk of the financial asset. If shares are being considered, E(rm) is the required return of
of the line, and E(ri) as the values being plotted on the straight line. The line itself is called the security market line (or SML), as shown in Figure
1.
In order to use the CAPM, investors need to have values for the variables contained in the model.
To ensure consistency of data, the yield on UK treasury bills is used as a substitute for the risk-free rate of return when applying the CAPM to
shares that are traded on the UK capital market. Note that it is the yield on treasury bills which is used here, rather than the interest rate on
treasury bills. The yield on treasury bills (sometimes called the yield to maturity) is the cost of debt of the treasury bills.
Because the CAPM is applied within a given financial system, the risk-free rate of return (the yield on short-term government debt) will change
depending on which country’s capital market is being considered. The risk-free rate of return is also not fixed, but will change with changing
economic circumstances.
out short-term changes in the equity risk premium, a time-smoothed moving average analysis can be carried out over longer periods of time,
often several decades. In the UK, when applying the CAPM to shares that are traded on the UK capital market, an equity risk premium of
between 3.5% and 4.8% appears reasonable at the current time (Watson, D. and Head, A. (2016) Corporate Finance: Principles and Practice,
Beta
Beta is an indirect measure which compares the systematic risk associated with a company’s shares with the systematic risk of the capital
market as a whole. If the beta value of a company’s shares is 1, the systematic risk associated with the shares is the same as the systematic
risk of the capital market as a whole.
Beta can also be described as ‘an index of responsiveness of the returns on a company’s shares compared to the returns on the market as a
whole’. For example, if a share has a beta value of 1, the return on the share will increase by 10% if the return on the capital market as a whole
increases by 10%. If a share has a beta value of 0.5, the return on the share will increase by 5% if the return on the capital market increases by
10%, and so on.
Beta values are found by using regression analysis to compare the returns on a share with the returns on the capital market. When applying
the CAPM to shares that are traded on the UK capital market, beta values for UK companies can readily be found on the Internet, on
Datastream, and from the London Business School Risk Management Service.
EXAMPLE 1
Although the concepts of the CAPM can appear complex, the application of the model is straightforward. Consider the following information:
The CAPM predicts that the cost of equity of Ram Co is 10%. The same answer would have been found if the information had given the return
on the market as 9%, rather than giving the equity risk premium as 5%.
Asset betas, equity betas and debt betas
If a company has no debt, it has no financial risk and its beta value reflects business risk alone. The beta value of a company’s business
operations as a whole is called the ‘asset beta’. As long as a company’s business operations, and hence its business risk, do not change, its
asset beta remains constant.
When a company takes on debt, its gearing increases and financial risk is added to its business risk. The ordinary shareholders of the
company face an increasing level of risk as gearing increases and the return they require from the company increases to compensate for the
increasing risk. This means that the beta of the company’s shares, called the equity beta, increases as gearing increases (Watson, D. and
Head, A. (2016) Corporate Finance: Principles and Practice, 7th edition, Pearson Education Limited, Harlow pp289-90).
However, if a company has no debt, its equity beta is the same as its asset beta. As a company gears up, the asset beta remains constant,
even though the equity beta is increasing, because the asset beta is the weighted average of the equity beta and the beta of the company’s
debt. The asset beta formula, which is included in the formulae sheet, is as follows:
Note from the formula that if Vd is zero because a company has no debt, βa = βe, as stated earlier.
EXAMPLE 2
The next article will look at how the asset beta formula allows the CAPM to be applied in calculating a project-specific discount rate that can be
used in investment appraisal.
“
" Whenever an investment is made, for example in the shares of a
company listed on a stock market, there is a risk that the actual return on
the investment will be different from the expected return."
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