INTODUCTION

The cost of equity is more challenging to calculate as

equity does not pay a set return to its investors. Similar
to the cost of debt, the cost of equity is broadly defined
as the risk-weighted projected return required by
investors, where the return is largely unknown. The cost
of equity is therefore inferred by comparing the
investment to other investments (comparable) with
similar risk profiles to determine the "market" cost of
equity. It is commonly equated using the CAPM formula
CAPM MODEL WAS DEVELPOED IN MID
1960 BY 3 RESEARCHER WILLIAM SHARPE,
JOHN LINTNER AND ZAN
MOSSIN….INDEPENDENTLY.

In finance CAPM model is used to determine

theoretically appropriate required rate of
return of an asset, if the asset is to be added to
an already diversified portfolio
Assumption of CAPM model
Efficient capital market exist
No transaction cost is involved

Investment goals of investors are rational.

All investors having same expectations about the risk and return.

Capital market are in equilibrium

 Investor may borrow and lend without limit at risk-free rate of

interest.
Capital market is not dominated by any individual investors

Investors are risk averse

Securities or capital assets face no bankruptcy or insolvency.

 equation
 Cost of equity = Risk free rate of return +
Premium expected for risk
Cost of equity = Risk free rate of return + Beta x
(market rate of return- risk free rate of return)
Where Beta= sensitivity to movements in the
relevant market:
 Above equation requires the following three
parameters to estimate a firms cost of equity:
 1. The risk free rate
 2. The market risk premium
 3. The beta of the firms share
 (1). the risk free rate
 The yields on the government treasury
securities are used as the risk-free rate. You can
use returns either on the short term or the long
term treasury securities. It is a common
practice to use the return on the short term
treasury bills as the risk free rate. Since
investments are long term decisions, many
analysts prefer to use yields on long term
government bonds as the risk free rate.
 (2). the market risk premium
 The market risk premium is measured as the difference between the
long term, historical arithmetic average of market return and the risk
free rate. Some people use a market risk premium based on returns of
the most recent years. This is not a correct procedure since the
possibility of measurement errors and variability in the short term,
recent data is higher. As we explained in our previous posts the
variability (standard deviation) of the estimate of the market risk
premium will reduce when you use long serious of market returns and
risk free rates.
 (3). the beta of the firms share
 Beta is the systematic risk of an ordinary share in relation to the
market. In our previous posts, we have explained the regression
methodology for calculating beta for an ordinary share. The share
returns are regressed to the market returns to estimate beta.
 Benefits and Limitation
BENEFITS
•Investors can estimate the required rate of return.
•CAPM suggests the diversification of portfolio in
minimization

•LIMITATIONS
•Assumption of CAPM model doesn’t hold good
•In reality ,its difficult to estimate the risk free return,
market rate of return & risk premium.