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# The CAPM says that the expected return of a security or a portfolio equals the rate on a risk-free security plus

a risk premium. If this expected return does not meet or beat the required return, then the investment should not be undertaken. The security market line plots the results of the CAPM for all different risks (betas). Using the CAPM model and the following assumptions, we can compute the expected return of a stock in this CAPM

## Cost Of Capital - Cost Of Equity

The cost of equity is the return that stockholders require for their investment in a company. The traditional formula for cost of equity (COE) is the dividend capitalization model:

A firm's cost of equity represents the compensation that the market demands in exchange for owning the asset and bearing the risk of ownership. (Learn more about investing inHate Dealing With Money? Invest Without Stress and Investment Options For Any Income.) Here's a very simple example: let's say you require a rate of return of 10% on an investment in TSJ Sports. The stock is currently trading at \$10 and will pay a dividend of \$0.30. Through a combination of dividends and share appreciation you require a \$1.00 return on your \$10.00 investment. Therefore the stock will have to appreciate by \$0.70, which, combined with the \$0.30 from dividends, gives you your 10% cost of equity. A company that earns a return on equity in excess of its cost of equity capital has added value. (For more on ROE, read Keep Your Eyes On The ROE.)

Calculating the Cost of Equity The cost of equity can be a bit tricky to calculate as share capital carries no "explicit" cost. Unlike debt, which the company must pay in the form of predetermined interest, equity does not have a concrete price that the company must pay, but that doesn't mean no cost of equity exists. Common shareholders expect to obtain a certain return on their equity investment in a company. The equity holders' required rate of return is a cost from the company's perspective because if the company does not deliver this expected return, shareholders will simply sell their shares, causing the price to drop. The cost of equity is basically what it costs the company to maintain a share price that is theoretically satisfactory to investors. (For further reading on share price, see Top 5 Stocks Back From The Dead and The Highest Priced Stocks In America.) On this basis, the most commonly accepted method for calculating cost of equity comes from the Nobel Prize-winning capital asset pricing model (CAPM): The cost of equity is expressed formulaically below: Re = rf + (rm rf) * Where:

Re = the required rate of return on equity rf = the risk free rate rm rf = the market risk premium = beta coefficient = unsystematic risk

## But what does this mean?

Rf Risk-free rate - This is the amount obtained from investing in securities considered free from credit risk, such as government bonds from developed countries. The interest rate

of U.S. Treasury Bills is frequently used as a proxy for the riskfree rate. Beta - This measures how much a company's share price reacts against the market as a whole. A beta of one, for instance, indicates that the company moves in line with the market. If the beta is in excess of one, the share is exaggerating the market's movements; less than one means the share is more stable. Occasionally, a company may have a negative beta (e.g. a gold-mining company), which means the share price moves in the opposite direction to the broader market. (Learn more inBeta: Know The Risk.) For public companies, you can find database services that publish betas. Few services do a better job of estimating betas than BARRA. While you might not be able to afford to subscribe to the beta estimation service, this site describes the process by which they come up with "fundamental" betas. Bloomberg and Ibbotson are other valuable sources of industry betas. (Rm Rf) = Equity Market Risk Premium (EMRP) - The equity market risk premium (EMRP) represents the returns investors expect to compensate them for taking extra risk by investing in the stock market over and above the risk-free rate. In other words, it is the difference between the risk-free rate and the market rate. It is a highly contentious figure. Many commentators argue that it has gone up due to the notion that holding shares has become more risky. The EMRP frequently cited is based on the historical average annual excess returnobtained from investing in the stock market above the risk-free rate. The average may either be calculated using an arithmetic mean or a geometric mean. The geometric mean provides an annually compounded rate of excess return and will in most cases be lower than the arithmetic mean. Both methods are popular, but the arithmetic average has gained widespread acceptance.

Once the cost of equity is calculated, adjustments can be made to take account of risk factors specific to the company, which may increase or decrease a company's risk profile. Such factors include

the size of the company, pending lawsuits, concentration of customer base and dependence on key employees. Adjustments are entirely a matter of investor judgment, and they vary from company to company. (Learn more in The Capital Asset Pricing Model: An Overview.)

It is important to note that the cost of newly issued stock is higher than the company's cost of retained earnings. This is due to the flotation costs. (For more on newly issued stock, see Why Investors Can't Get Enough Of Social Media IPOs and 5 Signs That Social Media Is The Next Bubble.) Weighted Average Cost of Equity Weighted average cost of equity (WACE) is a way to calculate the cost of a company's equity that gives different weight to different aspects of the equities. Instead of lumping retained earnings, common stock and preferred stock together, WACE provides a more accurate idea of a company's total cost of equity. Here is an example of how to calculate WACE: First, calculate the cost of new common stock, the cost of preferred stock and the cost ofretained earnings. Let's assume we have already done this and the cost of common stock, preferred stock and retained earnings are 24%, 10% and 20% respectively.

Now, calculate the portion of total equity that is occupied by each form of equity. Again, let's assume this is 50%, 25% and 25%, for common stock, preferred stock and retained earnings, respectively.

Finally, multiply the cost of each form of equity by its respective portion of total equity, and sum of the values to get WACE. Our

example results in a WACE of 19.5%. WACE = (.24*.50) + (.10*.25) + (.20*.25) = 0.195 or 19.5% Determining an accurate cost of equity for a firm is integral in order to be able to calculate the firm's cost of capital. In turn, an accurate measure of the cost of capital is essential when a firm is trying to decide if a future project will be profitable or not.
The capital asset pricing model provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk free rate plus beta times the difference of the return on the market and the risk free rate.

## Risk and the Capital Asset Pricing Model Formula

To understand the capital asset pricing model, there must be an understanding of the risk on an investment. Individual securities carry a risk of depreciation which is a loss of investment to the investor. Some securities have more risk than others and with additional risk, an investor expects to realize a higher return on their investment. For example, assume that an individual has \$100 and two acquaintances would like to borrow the \$100 and both are offering a 5% return(\$105) after 1 year. The obvious choice would be to lend to the individual who is more likely to pay, i.e., carries less risk of default. The same concept can be applied to the risk involved with securities. The risk involved when evaluating a particular stock is accounted for in the capital asset pricing model formula with beta. Specifically regarding the capital asset pricing model formula, beta is the measure of risk involved with investing in a particular stock relative to the risk of the market. The beta of the market would be 1. An individual security with a beta of 1.5 would be as proportionally riskier than the market and inversely, a beta of .5 would have less risk than the market. Risk Free Rate in the Capital Asset Pricing Model Formula The risk free rate would be the rate that is expected on an investment that is assumed to have no risk involved. For the US, the US treasury bill rate is generally used as it is short term and the collapse of the treasury bill would theoretically, at minimum, be a large enough disruption to inhibit gauging value, or at worse, be a collapse of the entire monetary system which relies on a fiat currency.

## Risk Premium in the Capital Asset Pricing Model Formula

The capital asset pricing model formula can be broken up into two components: the risk free rate and the risk premium of the particular security.

The risk premium is beta times the difference between the market return and a risk free return. In the capital asset pricing model formula, by subtracting the market return from a risk free return, the risk of the overall market can then be determined. By multiplying beta times this risk of the market, the risk of the individual stock can then be determined. As previously stated, beta is the risk of an individual security relative to the market. A beta of 2 would be twice as risky as the market. In practice, risk is synonymous with volatility. A stock with a beta larger than the market beta of 1 will generally see a greater increase than the market when the market is up and see a greater decrease than the market when the market is down.

## Alternative Capital Asset Pricing Model Formula

When regression analysis is applied to the capital asset pricing model based on prior returns, the formula will be shown as above. Alpha is considered to be the risk free rate and epsilon is considered to be the error in the regression.

Financial Leverage
Financial leverage can be defined as the degree to which a company uses fixed-income securities, such as debt and preferred equity. With a high degree of financial leverage come high interest payments. As a result, the bottom-line earnings per share is negatively affected by interest payments. As interest payments increase as a result of increased financial leverage, EPS is driven lower. As mentioned previously, financial risk is the risk to the stockholders that is caused by an increase in debt and preferred equities in a company's capital structure. As a company increases debt and preferred equities, interest payments increase, reducing EPS. As a

result, risk to stockholder return is increased. A company should keep its optimal capital structure in mind when making financing decisions to ensure any increases in debt and preferred equity increase the value of the company. Degree of Financial Leverage This measures the percentage change in earnings per share over the percentage change in EBIT. This is known as "degree of financial leverage" (DFL). It is the measure of the sensitivity of EPS to changes in EBIT as a result of changes in debt. Formula 11.19
DFL = percentage change in EPS or EBIT percentage change in EBIT EBIT-interest

A shortcut to keep in mind with DFL is that, if interest is 0, then the DLF will be equal to 1. Example: Degree of Financial Leverage With Newco's current production, its sales are \$7 million annually. The company's variable costs of sales are 40% of sales, and its fixed costs are \$2.4 million. The company's annual interest expense amounts to \$100,000 annually. If we increase Newco's EBIT by 20%, how much will the company's EPS increase? Answer: The company's DFL is calculated as follows: DFL = (\$7,000,000-\$2,800,000-\$2,400,000)/(\$7,000,000\$2,800,000-\$2,400,000-\$100,000) DFL = \$1,800,000/\$1,700,000 = 1.058 Given the company's 20% increase in EBIT, the DFL indicates EPS will increase 21.2%