The world of finance and valuation is a mix of art and science where every variable utilized has its own significance and a discount rate or required rate of return is one of them. Weighted Average Cost of Capital (WACC) is the discount rate which is used in Discounted Cash Flow analysis which consists of two main components – Cost of Equity and Cost of Debt whereby weights are assigned to them as per the company’s capital structure. As estimation of costs is one of the critical analysis, Capital Asset Pricing Model (CAPM) is one of the approaches utilized to assess Cost of Equity.
CAPM is used to estimate the expected return from an investment as it delineates the relationship between the risk of a particular asset and its expected return. The model is based on the relationship between an asset’s beta, the risk-free rate and the equity risk premium (ERP) where Beta represents systematic risk which is the sensitivity of the asset or the portfolio to changes in the markets; risk-free rate is the expected return on risk-free securities over a time horizon consistent with the investment horizon; and ERP is basically the excess return that market provides over risk-free rate. The general formula used for CAPM is:
CAPM, a theoretical representation of the behavior of financial markets, is quite significant to the operations of financial world as it serves as a model for pricing the risk in all securities, and thus helps investors evaluate and measure portfolio risk and returns anticipated for taking such risks. The theory contends that investors are rewarded only for assuming systematic risk, because investors can mitigate diversifiable risk by building a portfolio of both risky stocks and sound ones.
- hub
- About Us
- Services
- ASC and IRC Valuations
- Equity and Industry Research
- Business Valuation and Advisory
- Transaction Advisory Services
- Tangible Valuations
- Deal Analytics
- Buy-Side Due Diligence
- Economic Research
- Litigation Support
- Exit and Outcome Modelling
- Merger and Acquisition
- Purchase Price Allocation
- Market Research
- What’s it Worth Report
- Blog | Press
- Contact