Tag: the capm

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• CAPM is just a “model” or formula used to calculate COST OF EQUITY

 

• Cost of Equity is how much an investor “wants” to earn for investing in a company which is more risky than a safe bank deposit (or government bond), and (usually) more risky than investing in the general stock market with a bunch of stocks.

 

• It’s called a “cost” because that’s how much you should “fairly” pay your investors for investing in your risky company.

 

• In more complicated problems, you include the cost of equity as part of your WACC or Weighted Average Cost of Capital

 

• Assumes that investing in many stocks is safer than investing in just one company’s stock: “don’t put all your eggs in one basket” sorta thing.. this is called “diversified” risk

 

• Rationale: An investor would “want” (or “expect”) more income (“return”) for investing in a highly risky company instead of the zero-risk  bank/bond, and also instead of investing in a “medium-risk” general stock market.  Therefore, cost of equity = “expected return”

 

You calculate Cost of Equity using the CAPM or Capital Asset Pricing Model Formula:

K_e = R_f + B (R_m-R_f)

DON’T panic! It’s MUCH  EASIER than it looks! See this formula step-by-step in action, watch it for free in the video above.