# 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.

## 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)

Where

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.

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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# Return on Asset Definition

Return on asset (ROA) reveals how much profit a company earned in comparison to its overall asset. The value of ROA varies from industry and company. In general, the higher the value, the better a company is.

## Return on Asset Formula

Return on Asset = Net income ÷ Average asset

Or = Net profit margin * Asset turnover

## Return on Asset Calculation

Example: a company has \$2,000 in net income, and \$20,000 in average asset. Return on equity = 2,000 / 20,000 = 10%

This means that has \$0.1 of net income for every dollar of asset invested.

## Applications

Return on assets measures profit against the assets a company used to generate revenue. It is an important indicator of the asset intensity of a company. A lower ratio means a company is more asset-intensive, and vice versa. Additionally, a more asset-intensive company needs more money to continue generating revenue. Return on asset ratio is useful for investors to assess a company’s financial strength and efficiency to use resources. It is also very important for management to measure its performance against its planned business goals, or market competitors. Strategic CFO Lab Member Extra

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For statistical information about industry financial ratios, please go to the following websites: www.bizstats.com and www.valueline.com.

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# Finance Beta Definition

The finance beta definition, or beta coefficient, measures an asset’s sensitivity to movements in the overall stock market. It is a measure of the asset’s volatility in relation to the stock market.

To calculate the beta of an asset, use regression analysis to compare the historic returns of the asset with the historic returns of the stock market. Many often calculate beta using at least five years of historic data.

An asset with a beta of one will fluctuate with the overall stock market. Whereas, an asset with a beta higher than one is more volatile than the stock market. An asset with a beta less than one is less volatile than the stock market. In addition, an asset with a negative beta coefficient moves inversely to the stock market. Beta is used to compute an asset’s expected return in the capital asset pricing model.

The advantage of using beta is that it is useful way to gauge an asset’s volatility in relation to the overall stock market. The disadvantage of using beta is that it is based on historical data and may not necessarily be an accurate predictor of future volatility.

### Beta of Stocks

The beta of stocks measures that stock’s sensitivity to movements in the overall stock market. More volatile stocks have a beta higher than one; less volatile stocks have a beta less than one.

For example, if a stock has a beta of 1.5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by 15%. (15% = 1.5 x 10%). If a stock has a beta of .5, and the return on the overall stock market rises by 10%, then the return on this stock is expected to rise by only 5%. (5% = .5 x 10%). If a stock has a beta of -1, and the return on the overall stock market rises by 10%, then the return on that stock is expected to decline by 10%. (-10% = -1 x 10%).

### Beta of Portfolio

You can also use beta to measure the volatility of an entire portfolio. The beta of a portfolio is simply a weighted average of the assets within the portfolio.

For example, if 50% of the portfolio is comprised of an asset with a beta of .5, and the other 50% of the portfolio is comprised of an asset with a beta of 2, then the portfolio beta would be 1.25. (1.25 = (.5 x .5) + (.5 x 2)).

Similarly, if 25% of the portfolio is comprised of an asset with a beta of .5 and the other 75% of the portfolio is comprised of an asset with a beta of 2, then the beta of the portfolio would be 1.625. (1.625 = (.25 x .5) + (.75 x 2)).

### Beta of Market Portfolio

The beta of market portfolio is always one. Because beta measures the sensitivity of an asset to the movements of the overall market portfolio, and the market portfolio obviously moves precisely with itself, its beta is one. Strategic CFO Lab Member Extra

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