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Capital Asset Pricing Model (CAPM)

See Also:
Cost of Capital
Cost of Capital Funding
Arbitrage Pricing Theory
APV Valuation
Capital Budgeting Methods
Discount Rates NPV
Required Rate of Return

Capital Asset Pricing Model (CAPM)

The most popular method to calculate cost of equity is Capital Asset Pricing Model (CAPM). Why? Because it displays the relationship between risk and expected return for a company’s assets. This model is used throughout financing for calculating expected returns for assets while including risk and cost of capital.

Cost of Equity

Also known as the required rate of return on common stock, define the cost of equity as the cost of raising funds from equity investors. It is by far the most challenging element in discount rate determination.

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Calculating Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) states that the expected return on an asset is related to its risk as measured by beta:

E(Ri) = Rf + ßi * (E(Rm) – Rf)

Or = Rf + ßi * (risk premium)


E(Ri) = the expected return on asset given its beta

Rf = the risk-free rate of return

E(Rm) = the expected return on the market portfolio

ßi = the asset’s sensitivity to returns on the market portfolio

E(Rm) – Rf = market risk premium, the expected return on the market minus the risk free rate.

Expected Return of an Asset

Therefore, the expected return on an asset given its beta is the risk-free rate plus a risk premium equal to beta times the market risk premium. Beta is always estimated based on an equity market index. Additionally, determine the beta of a company by the three following variables:

  1. The type business the company is in
  2. The degree of operating leverage of the company
  3. The company’s financial leverage

Risk-Free Rate of Return

Short-term government debt rate (such as a 30-day T-bill rate, or a long-term government bond yield to maturity) determines the risk-free rate of return. When cash flows come due, it is also determined. Define risk-free rate as the expected returns with certainty.

Risk Premium

Additionally, risk premium indicates the “extra return” demanded by investors for shifting their money from riskless investment to an average risk investment. It is also a function of how risk-averse investors are and how risky they perceive investment opportunities compared with a riskless investment.

Cost of Equity Calculation

For example, a company has a beta of 0.5, a historical risk premium of 6%, and a risk-free rate of 5.25%. Therefore, the required rate of return of this company according to the CAPM is: 5.25% + (0.5 * 6%) = 8.25%

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Capital Asset Pricing Model (CAPM)

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Capital Asset Pricing Model (CAPM)

Originally published by Jim Wilkinson on July 23, 2013. 

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Risk Premium

See Also:
Finance Beta Definition
Hedging Risk
Common Stock
Preferred Stock
Stock Options

Risk Premium Definition

Risk premium is any return above the risk-free rate. The risk-free rate refers to the rate of return on a theoretically riskless asset or investment, such as a government bond. All other financial investments entail some degree of risk, and the return on the investment above the risk-free rate is called the risk premium.

When an investor purchases a financial instrument, such as stock or bonds, that investor is putting his capital at risk. The company that issued the stock could perform poorly and its stock could plummet in value; or the company issuing the bonds could default and its bonds could become worthless. Both of these potential scenarios represent risk for the investor or speculator. The return on an investment, which corresponds to the riskiness of the investment, is supposed to compensate the investor for that risk.

Different financial instruments have different degrees of riskiness and the returns on these instruments typically correspond with the level of risk. More risky assets have higher returns; less risky assets have lower returns. An asset with no risk, such as a U.S. government bond, has a comparatively low rate of return because there is little or no risk of the U.S. government defaulting. Therefore, the rate of return on that type of riskless asset is referred to as the risk-free rate. Any return above that rate is a risk premium which compensates the investor for the riskiness of the asset.

Risk Premium Example

Assume the risk-free rate is 5%. This means a riskless U.S. government treasury bond offers an annual return of 5%. Let’s say an investor invests in the stock of a company and that stock has an annual return of 7%. The risk premium for that company’s stock is the difference between the risk-free rate of 5% and the expected return of the stock of 7%. So the risk premium is 2%.

Risk Premium = Asset Return – Risk-Free Rate

2% = 7% – 5%

Risk Premium and the CAPM

The risk premium is also used in calculating the expected return on asset when using the capital asset pricing model (CAPM). In that case, the risk premium combines the market risk premium, or the overall stock market’s return above the risk-free rate, with the beta of the individual stock. This gives the risk premium for the particular stock over the risk-free rate.

risk premium

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Paid in Capital (APIC)

See Also:
Common Stock Definition
Preferred Stocks (Preferred Share)
Treasury Stock (Repurchased Shares)
Owner’s Equity
Balance Sheet

Paid in Capital Definition

The paid in capital definition is the total amount paid on equity or stock over the par value of the stock. In addition, it is a balance sheet account in the stockholder’s equity section. This account simply represents the market value over the book value of the equity. It is also called the premium stock, premium on stock, or additional paid in capital (APIC).

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Paid in Capital Equation

The following paid in capital equation is simply put as the amount paid for the stock over the par value of the stock:

Amount Paid Common Stock – Par Value Common Stock = Additional Paid in Capital

Usually the amount paid for the stock is at the market value so the following formula can also be looked at:

Market Value Stock – Book (par) Value Stock = Additional Paid in Capital

Paid in Capital Example

For example, Yazoo inc. is looking to make a public offering in the market for $2 par value common stock in the amount of 100,000 shares. Thus, the book value of the common stock is $200,000. The investment bank believes that the company will be able to receive a price based on its current market value of stock at $20 per share. Yazoo is unsure that they can receive this price. So, they opt to sell the stock at $19 per share first to the investment bank allowing them to make the offering. They can now debit cash in the amount of $1.9 million. Yazoo will also credit common stock for $200,000 or the book value, and it will also credit the additional paid in capital (APIC) account for the remainder of $1.7 million.

Note: If successful in supplying the market with the stock, then the investment bank will make a profit of $1 million dollars that Yazoo would not see. However, many companies perform this same maneuver to take the volatility of the market out of the equation allowing Yazoo to lock in a price for the financing that they will receive. This is where the term underwriting comes from when referring to investment banking.

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Paid in Capital Definition, Paid in Capital Equation, Paid in Capital
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Paid in Capital Definition, Paid in Capital Equation, Paid in Capital


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Avoid Insurance Premiums

See Also:
Selecting Your Insurance Broker
Evaluating and Renewing Employee Health Insurance Plan
Insulate Your Company from Rising Health Insurance Costs
Risk Premium
Service Department Costs

Avoid Insurance Premiums

Many companies have been hit with unexpected additional premium at the expiration of their general liability insurance policy. Below are the steps to determine if and when a policy will be audited. We’ll also discuss how to determine the actual earned premium for the policy term.

Steps to Avoid Insurance Premiums

1. Determine Whether the Company Policy is Auditable or Not

Review the declaration page of the policy for reference to audit basis. If the policy declaration page has words similar to the following, then the insured should not experience an unexpected premium at the end of the policy.

* Audit Period: Non-Auditable

* This premium is subject to adjustment with an audit. Yes or No

* Non-Auditable unless circle one of the following: Monthly, Quarterly ,Semi-Annual or Annual

* Premium is: Auditable or Flat

If the policy declaration page does not contain any similar combination of the above words, then look within the body of the policy. Common areas to look at are the Common Policy Conditions, Composite Rate Endorsement, and Business Owners Common Policy Conditions.

If the policy is auditable, as many are for bigger businesses, then the insured should proceed to step two.

2. Determine How the Original Premium was Calculated

Once the insured knows the policy is auditable, they need to know how the policy calculated the original premium. The policy premium calculation starts with the insurance carrier classifying the business. Contracting, retail, manufacturing, and building owners are four main classes of business. Once the insurance carrier determines the class of business, they will know what premium base to use. The four main premium bases are gross sales, payroll, area, or number of units. Then multiply this premium base by a dollar rate that the insurance industry or the carrier assigns that class of business. Usually the insured can find this base rate number within the declaration page, on a rating worksheet, or by asking the agent.

3. Calculation of Estimated Annual Premium

For example, a retail store’s premium base is $1,000 per gross sales. If the dollar rate were $.50 per $1,000 of gross sales, the initial premium would be $50.00 a year. $100,000/$1,000 * .50 = $50.00 would be the estimated premium for the year.

4. Calculation of the Unexpected Premium

If the insured knows or believes sales, units, area will be greater than the insurance carrier based the initial premium upon, the insured should prepare for added general liability premium costs.

For example, if the insured is expecting $500,000 in total annual sales rather than $100,000, the added premium would be as follows:

$400,000/$1,000 * .50 = $200.00 added premium. Now if the insured added a couple of zeros to the equation with either sales or rates the insured could see a large balance owed at the end of the policy term. Knowing whether the general liability premium is auditable could save the insured a significant amount in unexpected premium at the end of the policy.

5. If the Premium Base (Estimated Sales, Units, Area, etc…)

If the premium base (estimate sales, units, area, etc.) is not in line with the initial premium charged the insured needs to calculate the correct annual premium and let the carrier know. The sooner the better.

There are a couple of reasons to let the insurance carrier know. The first is so the insured can adjust cash flow. The insured also needs to either start paying more premium now or be prepared at audit time to pay immediately. The second reason to let the carrier know earlier is that sometimes the insured is able to get a lower rate than what will probably be charged at expiration.

As always, it is best to avoid the unexpected surprises by thoroughly evaluating the general liability premium with the agent either before binding the policy or when they deliver the policy to your office.

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Excess Insurance Definition

See Also:
Evaluating and Renewing Employee Health Insurance Plan
How to avoid additional insurance premiums
Insulate Your Company from Rising Health Insurance Costs
How to Select Your Commercial Insurance Broker
Contract Price

Excess Insurance Definition

Defined as insurance which extends beyond the limitations of other policies, excess insurance is a common method of mitigation of loss.

Excess Insurance Meaning

Excess insurance means insurance which covers loss beyond the scope of primary coverage. With an excess insurance policy, a company does not need to pay for the loss beyond their existing insurance policy. Instead, they can purchase excess insurance and pay only the deductible on this. Excess insurance only covers loss beyond a certain, set amount.

Excess insurance coverage provides protection for those who can afford another insurance policy. The common insurance factors still remain true. This means premiums must be paid, and when loss is experienced a deductible must also be paid. Excess coverage, also known as an umbrella policy, is virtually the same as primary insurance.

Excess Insurance Example

Dean owns a shrimping business on the gulf coast. He follows in the footsteps of his father, and his father before him. This means that Dean is continuing the family business. One day, he wants to pass this on to his children.

Dean has recently experienced tragedy. His business, small but profitable, has been devastated. When a recent hurricane came into the gulf coast it wiped out all of his assets, leaving him with only a company name and some cash in the bank. Unfortunately, the damaged well exceeds his primary insurance policy.

Luckily, Dean has an excess insurance carrier. Though he will still have to pay an insurance deductible, he will not experience the losses to his business. It will take time, but he will be able to rebuild from this catastrophe. Dean goes home and prepares for the storm ahead of him; filing with his excess insurance authority.

excess insurance definition

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Convertible Debt Instrument

See Also:
Company Valuation
Coupon Rate Bond
Covenant Definition of a Bond Contract
Long Term Debt
Non-Investment Grade Bonds
Par Value of a Bond
Preferred Stocks

Convertible Debt Instrument (Bond)

A convertible bond is a debt instrument issued by a company that can be exchanged for shares of that company’s common stock. The price at which the bond can be converted into stock, or the conversion price, is typically set when the bond is issued. The bond can be converted at any point up until maturity.

Like standard nonconvertible bonds, issue a convertible bond with a set par value, maturity date, and coupon rate.

Convertibles are attractive instruments to investors because they combine the reliability of a debt instrument with the potential upside profits of shares of stock. If the company’s stock goes down, the convertible bondholder is not adversely affected. If the company’s stock goes up, the investor can profit from the conversion. The downside, however, is that a convertible bond will offer the investor a lower yield than a nonconvertible bond. This is because of the potential benefits of conversion feature. Convertible bonds are also typically callable, which means the issuing company can force the investor to convert the bond for a specified number of shares of stock at a certain price.

Issuing a convertible bond is an attractive financing option for a company because it is cheaper than issuing a nonconvertible bond. The benefits of the conversion feature allow the issuing company to pay a lower coupon rate to the bondholder. It is also a convenient way to raise funds without having to issue more common stock or standard debt instruments. On the downside, the convertible bond will dilute the company’s stock if converted.

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Convertible Bond Premium

The convertible bond premium, or conversion premium, is the difference between the current stock price and the conversion price. For example, if a convertible bond can be exchanged for stock at $50 per share, and the current stock price is $45, then the conversion premium is $5.

Conversion Ratio Formula

The conversion ratio measures the number of shares of common stock the investor will receive in exchange for a convertible bond. The conversion ratio is often set at the issuance of the convertible instrument.

Conversion Ratio = Par Value of Convertible Bond / Conversion Price

For example, if the par value of the convertible bond is $1,000 and the conversion price is $50, then the conversion ratio equals 20. The investor could receive 20 shares of stock in exchange for each convertible bond.

Conversion Value Formula

The conversion value of a convertible bond is the value of the instrument in terms of the underlying stock. If the conversion value is greater than the par value, then the investor earned a profit. If the conversion value is less than the par value, the investor has made a profit.

Conversion Value = Current Stock Price x Conversion Ratio

For example, if the par value is $1,000, the conversion ratio is 20, and the stock price is $40, then the conversion value is $800. The investor would not want to convert. However, given the same par value and conversion ratio, if the stock price were $55, then the conversion value would be $1,100. In this case, the investor might want to convert the bond into stock and take the profit of $100.

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convertible debt instrument

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Insulate Your Company from Rising Health Insurance Costs

Refer to the following wiki about how to insulate your company from rising health insurance costs:

Insulate Your Company from Rising Health Insurance Costs

“How many times have your employees — or even potential employees — expressed concerns about the cost of the health insurance that your small business provide? It’s an employee concern that most small business owners dread discussing because providing comprehensive health care can be a substantial cost burden. There are small business owners who can afford to provide a competitive benefits package in the short-term[; however,] many are not aware that their rates can increase in the long-term as the result of employee illnesses… [Some of these illnesses] require substantial medical care and cost.

Going It Alone

Often times, small businesses implement a health insurance plan one year, only to see their costs skyrocket in subsequent years due to the health experience of their small employee base. If there have been health conditions that resulted in significant costs, insurance rates for the small group plan rise, and a once competitive plan becomes a cost burden to the company. When a small or medium-sized business obtains its own health care coverage and is faced with a significant rate increase due to the performance or cost burden generated by the small pool of employees, difficult choices emerge, [including the following]:

  • Eliminate or reduce coverage
  • Increase the employer contribution to the premium
  • Increase employee premiums

Partnerships Can Help

To help protect themselves from these types of increases, many small businesses choose to partner with a Professional Employer Organization (PEO). PEOs operate under a co-employment model… [It] is based on a commitment by the PEO… [They] share employment-related risk with clients, thereby helping to reduce financial exposure…”

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