How Do I Use the CAPM to Determine Cost of Equity?

What Is the Capital Asset Pricing Model (CAPM)?

Corporate accountants and financial analysts often use the capital asset pricing model (CAPM) in capital budgeting to estimate the cost of shareholder equity. Described as the relationship between systematic risk and expected return for assets, CAPM is widely used for the pricing of risky securities, generating expected returns for assets given the associated risk, and calculating costs of capital.

Cost of Equity CAPM Formula

The CAPM formula requires only the following three pieces of information: the rate of return for the general market, the beta value of the stock in question, and the risk-free rate.

The risk-free rate of return is the theoretical return of an investment that has zero risk. It's considered theoretical because every investment carries some amount of risk, however small. It generally assumes the rate of return that's offered by short-term government debt.

What the CAPM Can Tell You

The cost of equity is an integral part of the weighted average cost of capital (WACC). WACC is widely used to determine the total anticipated cost of all capital under different financing plans. WACC is often used to find the most cost-effective mix of debt and equity financing.

Assume Company ABC trades on the S&P 500 with a rate of return of 10%. The company's stock is slightly more volatile than the market with a beta of 1.2. The risk-free rate based on the three-month T-bill is 4.5%.

Based on this information, the cost of the company's equity financing is 11%: Cost of Equity = 4.5% + (1.2 * (10% - 4.5%)).

The Difference Between CAPM and WACC

The CAPM is a formula for calculating the cost of equity. The cost of equity is part of the equation used for calculating the WACC. The WACC is the firm's cost of capital. This includes the cost of equity and the cost of debt.

WACC can be used as a hurdle rate against which to evaluate future funding sources. WACC can be used to discount cash flows with capital projects to determine net present value. A company's WACC will be higher if its stock is volatile or seen as riskier as investors will demand greater returns to compensate for additional risk.

Limitations of Using CAPM

There are some limitations to the CAPM, such as agreeing on the rate of return and which one to use. Beyond that, there’s also the market return, which assumes positive returns, while also using historical data. This includes the beta, which is only available for publicly traded companies. The beta also only calculates systematic risk, which doesn’t account for the risk companies face in various markets.

Various assumptions must be made including that investors can borrow money without limitations at the risk-free rate. The CAPM also assumes that no transaction fees occur, investors own a portfolio of assets, and investors are only interested in the rate of return for a single period—all of which are not always true.

The Bottom Line

For accountants and analysts, CAPM is a tried-and-true methodology for estimating the cost of shareholder equity. The model quantifies the relationship between systematic risk and expected return for assets and applies to a multitude of accounting and financial contexts.