How Do I Use the CAPM to Determine Cost of Equity?

Reviewed by Thomas J. Catalano
Fact checked by Ryan Eichler

What Is the Capital Asset Pricing Model?

Corporate accountants and financial analysts often use the capital asset pricing model (CAPM) in capital budgeting to estimate the cost of shareholder equity. 

CAPM sums up the relationship between systematic risk and expected return for assets. It is widely used to generate expected returns for assets, given the associated risk and costs of capital.

CAPM can help companies decide on projects to undertake based on their relative cost of equity. It can help investors determine whether a particular investment is worthwhile, given the risk that it may not perform according to expectations.

Key Takeaways

• CAPM is used to calculate expected returns given the cost of capital and risk of assets.
• The CAPM formula requires the rate of return for the general market, the beta value of the stock, and the risk-free rate of return.
• The weighted average cost of capital (WACC) is calculated with the firm’s cost of debt and cost of equity—the latter of which is calculated using CAPM.
• CAPM limitations include having to agree on a rate of return and using assumptions.
• There are online cost of equity calculators, but calculating the formula by hand or by using Excel is relatively simple.

CAPM Formula

The CAPM formula requires only the following three pieces of information: the rate of return for the general market, the beta value of the stock in question, and the risk-free rate of return.

Cost of Equity = Risk-Free Rate of Return + Beta x (Market Rate of Return – Risk-Free Rate of Return)

The risk-free rate of return is the theoretical return of an investment that has zero risk. It’s considered theoretical because every investment carries some amount of risk, however small. It generally assumes the rate of return that’s offered by short-term government debt.

Important

Cost of equity is the rate of return that a company pays those who invest in its stock.

Use CAPM to Determine Cost of Equity

Here’s how to use CAPM to determine the cost of equity.

Assume Company ABC trades on the New York Stock Exchange and has a rate of return of 10%. The company’s stock is slightly more volatile than the market, with a beta of 1.2. The risk-free rate, based on the three-month T-bill, is 4.5%.

Using the CAPM formula, ABC can find out how much it would cost to finance a project using equity:

Cost of Equity = 4.5% + (1.2 * (10% – 4.5%))

Cost of Equity = 11%

ABC can now compare that rate (cost) to the cost of other financing options, such as borrowing, to see which makes the most sense for its financial means.

Numerous online calculators can determine the CAPM cost of equity, but calculating the formula by hand or by using Microsoft Excel is a relatively simple exercise.

CAPM and Beta

Beta is one of the important features of CAPM. It indicates a stock’s volatility—how much its price will move—relative to the overall market.

• A stock with a beta of 1 tends to move in line with the market.
• A beta that’s greater than 1 means the stock is more volatile than the market.
• A beta that’s less than 1 indicates less price volatility than the market.

If a stock has a beta of 1.5, it’s expected to be 50% more volatile than the market, moving up or down more sharply than the market.

In CAPM, beta is used to determine the expected return of an asset by factoring in its risk relative to the market.

CAPM assumes that investors need to be compensated for both the time value of money through the risk-free rate of return and the risk they take (through the market risk premium multiplied by beta).

A higher beta increases the expected return, reflecting the higher risk associated with more volatile stocks.

The Difference Between CAPM and WACC

CAPM is a formula for calculating the cost of equity. It is an integral part another formula used to calculate capital costs called the weighted average cost of capital (WACC).

WACC is widely used to determine the total anticipated cost of all capital under different financing plans. It is often calculated to find the most cost-effective mix of debt and equity financing.

WACC = [Cost of Equity x Percent of Firm’s Capital in Equity] + [Cost of Debt x Percent of Firm’s Capital in Debt x (1 – Tax Rate)]

WACC can be used as a hurdle rate against which to evaluate future funding sources. It also can be used to discount cash flows in capital projects to determine net present value.

A company’s WACC will be higher if its stock is volatile or seen as risky as investors will demand greater returns to compensate for a perceived higher risk.

Limitations of CAPM

There are some limitations to CAPM, such as the challenge of agreeing on the rate of return and which one to use.

Beyond that, there’s also the market return, which assumes positive returns, while also using historical data.

This includes the beta, which is only available for publicly traded companies. The beta also only calculates systematic risk, which doesn’t account for the market risk companies face.

Various assumptions are made for CAPM, one of which is that investors can borrow money without limitations at the risk-free rate.

CAPM also assumes that there are no transaction fees, that investors own a portfolio of assets, and that investors are only interested in the rate of return for a single period.

These assumptions are not always correct.

Why Cost of Equity Matters

As noted, the cost of equity represents the return that investors expect in exchange for investing their money in a company’s stock. Compared to safer investments, investors demand a higher return.

For businesses, understanding the cost of equity is key to making informed financial decisions. Before pursuing new projects or expansions, companies need to make sure the expected returns will exceed the cost of equity.

If a project’s return is lower than the cost of equity, it could diminish shareholder value rather than enhance it. This is because the ultimate cost of undertaking a project and financing it with stock may be higher than the return the company receives by investing in the project.

Whether through optimizing their capital structure, improving their risk profile, or choosing projects that promise strong returns, companies need to understand and control their cost of equity.

By understanding it, a company can make better financing decisions. For instance, a company may decide it will be cheaper to issue more debt to obtain funds than it would be to issue more stock.

Is CAPM the Same As Cost of Equity?

No, CAPM is a formula used to calculate the cost of equity—the rate of return a company pays to equity investors. For companies that pay dividends, the dividend capitalization model can be used to calculate the cost of equity.

What’s the CAPM Formula?

The CAPM formula is: Risk-Free Rate of Return + Beta x (Market Rate of Return – Risk-Free Rate of Return) = Cost of Equity.

What Are Some Potential Problems When Estimating the Cost of Equity?

The biggest issues when estimating the cost of equity include measuring the market risk premium, finding appropriate beta information, and using short- or long-term rates for the risk-free rate.

How Are CAPM and WACC Related?

CAPM determines the estimated cost of shareholder equity. WACC is the total cost of all capital (debt and equity). The cost of equity is part of the WACC formula.

The Bottom Line

For accountants and analysts, CAPM is a tried-and-true methodology for estimating the cost of shareholder equity. Investors also use it to compare rates of return of potential investments.

CAPM quantifies the relationship between systematic risk and expected return for assets and is useful in a multitude of accounting and financial contexts.