CAPM Formula

CAPM Formula

CAPM or capital asset pricing model Formula has been given below. CAPM formula has been explained with an easy example

CAPM = Rf + βe (Rm-Rf)

Rf= Risk Free Rate

Rm= Market Rate

βe = Equity Beta

Risk Free Rate

Risk Free rate is rate offered by the government on bonds. Bank offer rate in the country is also regarded as risk free rate. Risk free rate is lower than market rate due to lower risk.

Market Rate

Expected rate of return from the investment in the stock market is known as market rate or market rate of return. Market rate is expected to be higher than risk free return rate.

Application of CAPM

CAPM is used to calculate cost of equity, other important method of calculating the cost of equity is dividend valuation model. Cost of equity calculation has been explained below.

CAPM Formula Example

Stock Exchange Return Rate= 12%

Bank Risk Free Rate= 10%

Equity Beta= 1.6

Calculate Cost of equity?

Solution

= 10% + 1.6 ( 12%-10%)

=12%+1.6(2)%

=15.32%

 CAPM Formula Learning Example

Market Rate of Return= 13%

Risk Free Return (Rate)= 8%

Equity Beta= 1.3

Calculate Cost of equity?

Solution

= 8% + 1.3 ( 13%-8%)

=8%+1.3(5)%

=8% + 6.5%

=14.5%

Advantage of Using CAPM

CAPM takes into account two important concept of investment i.e. time value of money and risk. Time value of money is represented by risk free rate, while risk is represented by risk premium (premium for risk). Thus CAPM is a preferred method for cost of equity calculation.

Risk Premium = ( Rm-Rf)