7.2·7 min read
CAPM & the Cost of Equity
The cost of equity is the risk-free rate plus beta times the market risk premium. Riskier stock, higher demanded return.
By the end you can
- ✓Apply the CAPM formula
- ✓Identify where each input comes from
- ✓Compute a cost of equity end to end
Equity investors don't quote you a rate the way lenders do, so we infer their required return with the Capital Asset Pricing Model (CAPM). The idea: investors demand the plus a premium for bearing the stock's market risk.
| Input | Where it comes from |
|---|---|
| R_f () | Yield on the 10-year US Treasury |
| R_m - R_f () | Expected market return over risk-free; typically 5–8% |
| β () | Stock's sensitivity to the market; from Bloomberg or comps |
Worked example · Cost of equity for Max's Bikes
Given
- • R_f: 2%
- • β: 1.3
- •Market return R_m: 9%
Solution
- 1.Plug into
- 2.Compute
Answer
= 11.1%. The is 7%; a of 1.3 scales it to 9.1%, on top of the 2% risk-free base.
Check yourself
Risk-free rate 3%, beta 0.8, market risk premium 6%. What is the cost of equity?
Try it: cost of equity (CAPM)
Risk-free rate plus beta times the market risk premium.
Risk-free rate (Rf)3.0%
Beta1.20
Market risk premium6.0%
Cost of equity
10.2%
3.0% + 1.20 x 6.0%