CAPM – Capital Asset Pricing Model?
Every investment comes up with certain risk. Even equity has risk that there might be difference in the actual and the expected return. The cost of equity is, essentially, the discount rate applied to expect equity cash flows which helps an investor determine the price he or she is willing to pay for such cash flows. Investors being conservative by nature decide on taking the risk only when they can foresee the return they are expecting from an investment. Investors can calculate and get an idea of the required return on an investment, based on the assessment of its risk using Capital Asset Pricing Model i.e. CAPM.

Calculation of CAPM
The cost of equity (Ke) is the rate of return expected by shareholders. It can be calculated using the formula
      ·         Cost of equity = Risk free rate + Beta X Risk premium

         K_e = R_f +β * (R_m-R_f )

      ·         Cost of equity (Ke_{) =} the rate of return expected by shareholders
      ·         Risk free rate (rrf ) = the rate of return for a risk-free security
      ·         Risk premium ( R_p) = the return that equity investors demand over a risk-free rate
      ·         Beta (β) = A measure of the variability of a company’s stock price in relation to the stock market overall

Understanding the terminologies

Beta
Risk can be classified as systematic risk and unsystematic risk. Unsystematic risk is the risk that can be diversified. This risk arises due to the internal factors prevailing in an organization. For example workers have gone for a strike, customer’s commitments are not fulfilled, regulatory framework has a conflict with government policy etc.
Systematic risk is the risk that cannot be diversified. It is caused due to the external factors that affect an organization. It is uncontrollable in nature. For example, interest rate raises suddenly, Fluctuations of trading price of a security impacts the entire market etc. This risk can be measured with beta.
Beta measures the volatility of a security in comparison with the market as a whole.

Value of Beta	Descriptions
β=1	Stock is moving with the market’s pace. Both have equal growth or
β<1	Security is less volatile. Stock doesn’t move with the pace of market. i.e. if market up by 2% then stock moves less than 2%. i.e. @1% or less than that.
β>1	Security is highly volatile. Stocks pace is more than the market pace.

 

Risk free rate

 It is the minimum rate of return that an investor will receive if they in invest in a risk free security. Government bonds are known as risk free securities. For a security to be risk free security they should not have any default risk and re investment risk. Default risk is the risk where companies or individuals fail to repay their debt obligations. Re investment risk is the risk faced by an investor where the yield of the bonds are falling. As in this situation the investors have to reinvest their future income their yield or the final return of principal in securities which are lower yielding. So, not all governments securities are risk free securities

Risk premium
It is calculated using the formula Stock market return minus Risk free rate of return. It is the return that an investor expects above risk free rate of return in order to compensate for the risk of volatility that a person is taking by investing in the stock market. For example, if the investor gets a return of 20% and the risk free rate is 7% then the risk premium is 13%.

Assumptions for CAPM model

·         Investors don’t like to take risk. They would like to invest in a portfolio which has low risk. So if a portfolio has higher risk the investors expects a higher return.While making the investment decision investors take into consideration only single period horizon and not multiple period horizons.

·         Transaction cost in the financial market is assumed to be low cost and the investors can buy and sell the assets in any number at the risk free rate of return.

In CAPM, Values needs to be assigned for the risk free rate of return, risk premium and beta.
·         Risk free rate – The yield on the government bond is used as a risk free rate of return but it changes on a daily basis according to the economic circumstances
·         Beta – The value of beta changes over time. It is not constant. So the expected return might also differ.
·         Market Return – The stock market return can be calculated as the sum of theAverage capital gain and the average dividend yield. If the Shares prices falls and outweighs the dividend yield a stock market can provide a negative rather than a positive return