Capital Asset Pricing Model Approach.
Another technique that can be used to estimate the of equity is the capital asset pricing model (CAPM) approach. We first discuss the CAPM. As approach to measure the cost of equity capital, it is described subsequently.
The CAPM explains the behavior of security prices and provides a mechanism which investors could assess the impact of proposed security investment on their overall portfolio and return. In other words, it formally describes the risk return trade off for securities, it is on certain assumptions. The basic assumptions of CAPM are related to (a) the efficiency of security markets and (b) investor preferences.
The efficient market assumption implies that (i) all investors have common expectations regarding the expected returns, variances and correlation of, returns among all investors have the same information about securities; (ii) there are no restrictive investments: (iii) there are no taxes; (iv) there are no transaction costs; and (v) no single in can affect market price significantly.
The implication of investors preference assumption is that all investors prefer the security that provides the highest return for a given level of risk or the lowest amount of risk for a given level of return, that is, the investors are risk averse.
The risk to which security investment is exposed falls into two groups: (i) unsystematic, and (ii) non-unverifiable/systematic. The first represents that portion of the total risk of an investment that can be estimated/minimized through diversification. The events factors that cause such from firm to firm. The sources of such risks include management capabilities and decisions, strikes, unique government regulations, raw materials, competition, level of operating and financial leverage of the firm, and so on.
The systematic non-verifiable risk is uncharitable to tricolors that affect all firms illustrious sources of such risks are interest rate changes, inflation or purchasing power change changes in investor expectations about the overall performance of the economy and political changes. As consternation risk can be eliminated by an investor through diversification, they taciturn risk is the only relevant risk. Therefore. an investor (firm) should be concerned, according to CAPM, solely with the non-diversification statistic risk.
Systematic risk can be measured in relation to the risk of a diversified portfolio which is commonly referred to as the market portfolio or the market. According to CAPM, the diversification risk of an investment/security/ asset is assessed terms of the beta coefficient. Beta is a measure of the volatility of a security’s return clausal to the returns of a broad-based market portfolio. Alternatively, it is an index of the degree of responsiveness or co-movement of return en an investment with the market return. The beta for the market portfolio as measured by the broad based market index equals one. Beta coefficient of would imply that the risk of the specified security is equal to the market the interpretation of zero coefficient is that there is no market related risk to the investment. A negative coefficient would indicate a relationship in the opposite direction. The going required rate of return in the market for a given amount of systematic risk is called the Security Market Line (SML).