Why do we use CAPM to calculate cost of equity?? This model is not very intuitive and I'd like to learn more about the rational behind it.
Anyone?? Thanks!
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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.
Here's the proof.
http://www.columbia.edu/~ks20/FE-Notes/4700-07-Notes-CAPM.pdf
Thanks guys! Very helpful!
I think I am starting to get it now, slowly... But the first answer and the proof seem a bit complicated and too long.. is there any 1-2 sentence summary or explanation for the rationale?
Thanks!!!
You should put that summary together yourself based on the already extensive information provided. Will help you understand it better
Alternatives to calculating Cost of Equity other than CAPM (Originally Posted: 02/27/2018)
What are the other alternative methods to calculating Cost of Equity aside from CAPM and the Bond Yield Plus Risk Premium approach?
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