Sunday, April 11, 2010


Cost of Equity and Capital Asset Pricing Model

The Capital asset pricing model (CAPM) provides an alternative approach for the calculation of the cost of equity. As per the CAPM, the required rate of return on equity is given is given by the following relationship:

Ke = Rf + (Rm – Rf) Bi

Above equation requires the following three parameters to estimate a firm’s cost of equity:
  1. The risk free rate (Rf).
  2. The market risk premium (Rm – Rf).
  3. The beta of the firm’s share.

(1). the risk free rate

The yields on the government treasury securities are used as the risk-free rate. You can use returns either on the short term or the long term treasury securities. It is a common practice to use the return on the short term treasury bills as the risk free rate. Since investments are long term decisions, many analysts prefer to use yields on long term government bonds as the risk free rate. You should always use the current risk free rate rather than the historical average.

(2). the market risk premium

The market risk premium is measured as the difference between the long term, historical arithmetic average of market return and the risk free rate. Some people use a market risk premium based on returns of the most recent years. This is not a correct procedure since the possibility of measurement errors and variability in the short term, recent data is higher. As we explained in our previous posts the variability (standard deviation) of the estimate of the market risk premium will reduce when you use long serious of market returns and risk free rates.

(3). the beta of the firm’s share

Beta is the systematic risk of an ordinary share in relation to the market. In our previous posts, we have explained the regression methodology for calculating beta for an ordinary share. The share returns are regressed to the market returns to estimate beta. A broad based index like the BSE, sensitivity (senses) index is used as a proxy for the market.

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