Economics Capital Budgeting Questions Long
The Capital Asset Pricing Model (CAPM) is a financial model that helps in determining the expected return on an investment based on its systematic risk. It provides a framework for estimating the cost of equity, which is the return required by investors for holding shares in a company.
The CAPM is based on the principle that investors require compensation for two types of risks: systematic risk and unsystematic risk. Systematic risk refers to the risk that cannot be diversified away, such as market risk, interest rate risk, or inflation risk. Unsystematic risk, on the other hand, is specific to a particular company or industry and can be reduced through diversification.
The CAPM formula is as follows:
Expected Return on Equity (Re) = Risk-Free Rate (Rf) + Beta (β) * Equity Risk Premium (ERP)
- Risk-Free Rate (Rf): This is the return an investor would expect from a risk-free investment, such as a government bond. It represents the time value of money and compensates investors for the opportunity cost of investing in a risky asset.
- Beta (β): Beta measures the sensitivity of a stock's returns to changes in the overall market. It indicates how much the stock's price is expected to move in relation to the market. A beta of 1 means the stock moves in line with the market, while a beta greater than 1 indicates higher volatility and a beta less than 1 indicates lower volatility.
- Equity Risk Premium (ERP): This represents the additional return investors require for taking on the risk of investing in equities instead of risk-free assets. It compensates investors for the uncertainty and potential loss associated with investing in the stock market.
To estimate the cost of equity using the CAPM, the following steps are typically followed:
1. Determine the risk-free rate: This can be obtained by looking at the yield of a government bond with a similar maturity to the investment horizon.
2. Calculate the equity risk premium: This can be derived from historical data or by using market forecasts. It represents the average excess return of the stock market over the risk-free rate.
3. Calculate the beta: Beta can be obtained from financial databases or calculated using regression analysis. It measures the stock's sensitivity to market movements.
4. Plug the values into the CAPM formula: Once the risk-free rate, beta, and equity risk premium are determined, they can be used to estimate the cost of equity.
It is important to note that the CAPM has its limitations. It assumes that investors are rational and risk-averse, markets are efficient, and there is a linear relationship between risk and return. However, these assumptions may not always hold true in the real world. Therefore, the CAPM should be used as a tool for estimating the cost of equity, but it should be complemented with other valuation methods and considerations.