In capital budgeting, corporate accountants and financial analysts often use the capital asset pricing model (CAPM) 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.
Determining the Cost of Equity With CAPM
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
- The risk-free rate.
Ra=Rrf+[Ba∗(Rm−Rrf)]where:Ra=Cost of EquityRrf=Risk-Free RateBa=BetaRm=Market Rate of Return
The rate of return refers to the returns generated by the market in which the company's stock is traded. If company CBW trades on the Nasdaq and the Nasdaq has a return rate of 12%, this is the rate used in the CAPM formula to determine the cost of CBW's equity financing.
The beta of the stock refers to the risk level of the individual security relative to the broader market. A beta value of "one" indicates that the stock moves in tandem with the market. If the Nasdaq gains 5 percent, so does the individual security. A higher beta indicates a more volatile stock, and a lower beta reflects greater stability.
The risk-free rate is generally defined as the (more or less guaranteed) rate of return on short-term U.S. Treasury bills, because the value of this type of security is extremely stable, and the return is backed by the U.S. government. So, the risk of losing invested capital is virtually nil, and a certain amount of profit is guaranteed.
Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by hand or by using Microsoft Excel is a relatively simple exercise.
Assume CBW trades on the Nasdaq with a rate of return of 9 percent. 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 percent.
Based on this information, the cost of the company's equity financing is:
The cost of equity is an integral part of the weighted average cost of capital (WACC), which is widely used to determine the total anticipated cost of all capital under different financing plans in an effort to find the most cost-effective mix of debt and equity financing.
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 is applicable to a multitude of accounting and financial contexts.