Best Response

Because my finance textbook asked me to....

But anyway, CAPM tells you how much an investor needs to be compensated for the idiosyncratic risk he takes on an individual company. Talking from a company s perspective, that is how much you need to reward your investors in the future to get their money.

There are two parts in the equation - i/systematic risk (e.g. Financial crisis, when the whole stock market might go down altogether) Systematic risk is the same for all companies since they are all exposed to it.

ii/idiosyncratic risk (e.g. A drug of GSK failed at the clinical test stage) you use beta to measure the volatility of a specific company to the overall market. And the market will demand a "risk premium" for any additional risk they take on above the systematic risk.

Add these two together, it gives you the required rate of return for equity, aka cost of equity.

 

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