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Capital Asset Pricing Model Explained

The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return. It serves as a model for pricing risky securities. The CAPM equals the rate on a risk-free security plus a risk premium. Specifically, it is defined as Ke = Rf + β (Rm - Rf), where Ke is the expected return or cost of equity, Rf is the risk-free rate, β is a measure of the security's risk compared to the market, and Rm is the expected market return. The Weighted Average Cost of Capital (WACC) is used to calculate a firm's overall cost of capital by weighting the cost of each component (equity and debt) by its proportion of

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4 views12 pages

Capital Asset Pricing Model Explained

The Capital Asset Pricing Model (CAPM) describes the relationship between risk and expected return. It serves as a model for pricing risky securities. The CAPM equals the rate on a risk-free security plus a risk premium. Specifically, it is defined as Ke = Rf + β (Rm - Rf), where Ke is the expected return or cost of equity, Rf is the risk-free rate, β is a measure of the security's risk compared to the market, and Rm is the expected market return. The Weighted Average Cost of Capital (WACC) is used to calculate a firm's overall cost of capital by weighting the cost of each component (equity and debt) by its proportion of

Uploaded by

Pao Espi
Copyright
© All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

Capital Asset Pricing

Model
Describes the relationship between Risk and Expected
CAP Return
M Serves as a model for a pricing of risky securities
Equals the rate on a risk-free security plus a risk
premium
Capital
Asset
Pricing Ke = Rf + (Rm Rf)
Model
Ke = Rf + (Rm Rf)

6% Cost of Equity
risk Higher

?
premium Risk
Medium
Risk 10%
systema higher
tic risk

Earn 2%
Risk free 2%
risk free
No risk
rate
= 8%
Beta way to measure risk using volatility
compared to a commonly used system

If the beta stock of Riptide is 1.1, then that means when


the general stock market goes up by 20%, then Riptide
will go up by around 22%
Ke = Rf + (Rm Rf)

Rf = 2%
Rm = 8%
= 1.10

Ke = .02 + 1.1 (0.08 0.02)


Ke = .086 8.6% (cost of equity)
Weighted Average Cost of
Capital
WAC
C
Tax Shield

Weight
Equity Debt
ed
= x Re + x Rdx
)
Averag
e Cost Equity + Debt Equity + Debt ( 1 t
of
Capital
Cost of Equity Cost of Debt
Equity Debt
WACC = x Re+ x Rdx
)
Equity + Debt Equity + Debt ( 1 t
Debt = 2,000
Equity = 8,000
Rd = 6%
Re = 12.5%
Tax rate = 40%
8,000 2,000
= x.125 + x.06 x
8,000 + 2,000 8,000 + 2,000 (1 .40 )

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