Capital Asset Pricing Model (CAPM)

Used to calculate the cost of capital for investments, or at least the equity component within it.

CAPM is a theory that has been accepted and used for decades and its basic principle is that returns for any stock quoted on a stock market are comprised of two elements: a risk free rate of return (usually estimated from long-term government bond yields) and a modified equity risk premium. The equity risk premium is the average return, in excess of the risk free rate, that stock markets demonstrate over a long period of time. It is modified for a particular company by being multiplied by a Beta factor, which is one for the market as a whole (average risk overall). A high risk company will have a Beta in excess of one, which means that if the overall market moves by 10% (up or down) then its price will change by more than 10%. Conversely, a low risk company will have a Beta less than one and its price will change on average by less than 10%. Several companies collect the daily movement of stock prices, stretching back over many decades, in order to calculate both the equity risk premium and the Beta factors for quoted companies. There are established techniques for adding long-term debt costs to these equity costs in order to obtain an overall cost of capital and to modify them so they

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