capital asset pricing model

ž       CAPM

žCost of capital

žThere are three ways by which we determine cost of capital

žCost of debt

žCost of preferred stock

žCost of common stock

ž žEvaluation

      evaluation of CAPM is being by three methods respectively.

     Price of preferred stock 

     Bond valuation

     CAPM

                                                                        

   price of preferred stock  Pp= Dp / rp     

   Bond evaluation = R ( 1/i – 1/ i(i + Rd))

  CAPM rr = rRF +(RM – rRF )bl

                                                              

žCost of common stock  

žTheir are two factors by which cost of common stock be determined Retained earning and by New issued stock.

                      

žCAPM

žTo find retrained earning factor of common stock we use the formula named CAPM (capital asset pricing model)

žrr = rRF +(RM – rRF )bi

ž

žrr =required rate of return

žrRF =risk free rate of return

žRM = Market risk

žbi= beta coefficient

žRM – rRF= maturity risk premium (Rpm)

žExample

žSuppose following data is provided

žrRF= 5.5%

ž RM – rRF = 6%

ž bi= 0.8

     What is the firm cost of equity , using CAPM.

žSolution

rr = rRF +(RM – rRF )bi

     = 5.5+(6) 0.8

     = 10.3 %

ž