Why can the cost of equity be measured by the CAPM?

Expert Solution

The Capital Asset Pricing Model (CAPM) is a model that describes the relationship between the expected return.The expected return on an investment is the expected value of the probability distribution of possible returns it can provide to investors.

Cost of Equity can be measured by the capital asset pricing model(CAPM).The CAPM Model can be used on any stock, even if the company does not pay dividends. The theory suggests the cost of equity is based on the stock's volatility and level of risk compared to the general market.

Further, CAPM describes the relationship between systematic risk and expected return for assets. It is used for the pricing of risky securities, generating expected returns for an assets given the associated risk, and calculating costs of Equity

The CAPM formula is: Cost of Equity = Risk-Free Rate of Return + Beta * (Market Rate of Return - Risk-Free Rate of Return).

In this equation:

Risk-free rate: This is the rate of return paid on risk-free investments.

Beta: This is a measure of risk calculated as a regression on the company's stock price.

Market rate of return:This is the average market rate.

Therefore, Cost of Equity can be measured by the Capital asset pricing model(CAPM)

jeff jeffy answered 1 year ago

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