How to find Cost of Equity with Capital Asset Pricing Model (CAPM)?
Cost of equity, the minimum rate of return which a company must pay to its investors for their shares or investment in the Company, can be estimated using either the dividend discount model or the capital asset pricing model.
The CAPM (Capital Asset Pricing Model) is used when you have stocks that do not pay dividends. For stocks with dividend-paying, the Dividend growth model is useful. Learn how to calculate cost of equity using CAPM with this step by step tutorial.
Through the Capital Asset Pricing Model (CAPM), the Cost of Equity is determined as:
ra = rf + Ba (rm -rf)
rf = the rate of return on risk-free securities
Ba = the beta of the investment
rm = the markets overall expected rate of return
Step 1: Consider below Example:
Let us assume the following for a Company.
rf (rate of return) = 3 %
Ba (beta of investment) = 1.0
rm (marketsexpected rate of return) = 12%
Step 2: Substituting Values:
Cost of Equity = 3% + 1.0 x (12 % - 3 %)
= (3/100) + [1 x ((12/100)-(3/100))]
= (3/100) + [1 x ((12-3)/100)]
=(3/100) +[1 x (9/100)]
Converting into percentage,
= (12 / 100) x 100
= 12 %
Hence the Cost of Equity based on the CAPM (Capital Asset Pricing Model) for the given values of rate of return, beta of investment and markets expected rate of return is 12 % .