3.5.8.2. Capital Asset Pricing Model
You might wonder how to determine a company’s cost of equity for purposes of calculating WACC. Typically, an investment banker will look to a formula called the capital asset pricing model (CAPM). The calculation for cost of equity using CAPM is:
cost of equity = risk-free rate of return + (beta x market risk premium)
The risk-free rate of return is the expected rate of return of investing in U.S. Treasuries or other so-called risk-free investments. Beta, as previously discussed, is a measure of a stock’s volatility relative to the overall market. The market risk premium is the difference between the risk-free rate of return and the expected return of the overall market. An example of CAPM is in order.
Example: Assume the risk-free rate of return is 1% and that the company’s equity has a beta of 1.1 (i.e., somewhat more volatile than the market as a whole). The expected market rate of return is 8%. In this example, the market risk premium is 7% (the difference between the