Monday, December 14, 2009


Capital Asset Pricing Model and the Opportunity Cost of Equity

Shareholders supply capital to a form. In return, they expect to receive dividends. They can also realize cash by selling their shares.

The firm has discretion to retain entire or a part of profits. If dividends were distributed to shareholders, they would have an opportunity to invest cash so receive in securities in the capital markets and earn a return.

When a firm retains profits, there is loss of opportunity for which shareholders need to be compensated. The expected rate of return from a security of equivalent risk in the capital market is the cost of the lost opportunity. Shareholders require the firm to at least earn this rate on their capital invested in projects.

From the firms point of view the expected rate of return from a security of equivalent risk is the cost of equity.

We need the following information to estimate a firms cost of equity,
  • The risk free rate
  • The market premium
  • The beta of the firms share

The use of the industry beta is preferable for those companies whose operations match up with the industry operations.

The industry beta is less affected by random variations. Those companies that have operations quite different from a large number of companies in the industry may stick to the use of their own betas rather than the industry beta.

Let us emphasize that there is no theory for the selection of beta. Beta estimation and selection is an art as well, which one learns with experience.

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