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Capital Asset Pricing Model (CAPM):
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The Capital Asset Pricing Model (CAPM) calculates the expected return on equity investments. It represents the compensation investors require for taking on the additional risk of investing in a particular stock compared to a risk-free asset.
The calculator uses the CAPM formula:
Where:
Explanation: The formula calculates the expected return by adding the risk-free rate to the product of beta and the market risk premium (Rm - Rf).
Details: Cost of equity is a critical component in corporate finance for making investment decisions, valuing companies, and determining the cost of capital. It helps investors assess the risk-return tradeoff of equity investments.
Tips: Enter risk-free rate as a percentage (e.g., 2.5 for 2.5%), beta coefficient (typically between 0.5-2.0), and expected market return as a percentage. All values must be non-negative.
Q1: What is considered a good risk-free rate?
A: Typically, government bond yields (like 10-year Treasury notes) are used as risk-free rates. The specific rate depends on current market conditions.
Q2: How is beta coefficient determined?
A: Beta is calculated by regressing stock returns against market returns. A beta of 1 indicates volatility equal to the market, below 1 less volatile, above 1 more volatile.
Q3: What market return should I use?
A: Historical average market returns (typically 7-10% for major indices like S&P 500) are commonly used, though forward-looking estimates may also be appropriate.
Q4: Are there limitations to the CAPM model?
A: Yes, CAPM assumes efficient markets, rational investors, and that beta fully captures risk. It may not account for all risk factors in real-world scenarios.
Q5: How is cost of equity used in practice?
A: It's used in capital budgeting decisions, company valuation models (DCF), and as a component in calculating weighted average cost of capital (WACC).