In capital budgeting, corporate accountants and finance analysts often use the capital asset pricing model, or CAPM, to estimate the cost of shareholder equity. CAPM describes the relationship between systematic risk and expected return for assets. It 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 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.
Ra = Cost of Equity
Rrf = Risk-Free Rate
Ba = Beta
Rm = 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 percent, 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 wider market. A beta value of 1 indicates 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, or T-bills because the value of this type of security is extremely stable and return is backed by the U.S. government. So, the risk of losing invested capital is virtually zero, 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 in Microsoft Excel is simple.
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:
4.5 + 1.2 * (9 - 4.5), or 9.9%
The cost of equity is an integral part of the weighted average cost of capital, or WACC, which is widely used to determine the total anticipated cost of all capital under different financing plans, in an effort to find the mix of debt and equity financing that is most cost-effective.