314 Part 4 Investing in Long-Term Assets: Capital Budgeting
10-5a The CAPM Approach
The most widely used method for estimating the cost of common equity is the
Capital Asset Pricing Model (CAPM) as developed in Chapter 8.^12 Here are the
steps used to! nd rs:
Step 1: Estimate the risk-free rate, rRF. We generally use the 10-year Treasury bond
rate as the measure of the risk-free rate, but some analysts use the short-
term Treasury bill rate.
Step 2: Estimate the stock’s beta coef! cient, bi, and use it as an index of the stock’s
risk. The i signi! es the ith company’s beta.
Step 3: Estimate the expected market risk premium. Recall that the market risk
premium is the difference between the return that investors require on an
average stock and the risk-free rate.^13
Step 4: Substitute the preceding values in the CAPM equation to estimate the re-
quired rate of return on the stock in question:rs! rRF " (RPM)bi
10-5! rRF " (rM # rRF)biThus, the CAPM estimate of rs is equal to the risk-free rate, rRF , plus a risk pre-
mium that is equal to the risk premium on an average stock, (rM – rRF), scaled up or
down to re" ect the particular stock’s risk as measured by its beta coef! cient.
Assume that in today’s market, rRF! 5.6%, the market risk premium is RPM!
5.0%, and Allied’s beta is 1.48. Using the CAPM approach, Allied’s cost of equity
is estimated to be 13.0%:rs! 5.6% " (5.0%)(1.48)
! 13.0%Although the CAPM appears to produce an accurate, precise estimate of rs,
several potential problems exist. First, as we saw in Chapter 8, if a! rm’s stock-
holders are not well diversi! ed, they may be concerned with stand-alone risk rather
than just market risk. In that case, the! rm’s true investment risk would not be
measured by its beta and the CAPM estimate would understate the correct value
of rs. Further, even if the CAPM theory is valid, it is hard to obtain accurate esti-
mates of the required inputs because (1) there is controversy about whether to use
long-term or short-term Treasury yields for rRF , (2) it is hard to estimate the beta
that investors expect the company to have in the future, and (3) it is dif! cult to
estimate the proper market risk premium. As we indicated earlier, the CAPM
approach is used most often; but because of the just-noted problems, analysts also
estimate the cost of equity using the other approaches discussed in the following
sections.(^12) A recent survey by John Graham and Campbell Harvey indicates that the CAPM approach is most often used
to estimate the cost of equity. More than 70% of the surveyed $ rms used the CAPM approach. In some cases,
they used beta from the CAPM as one determinant of rs, but they also added other factors thought to improve
the estimate. For more details, see John R. Graham and Campbell R. Harvey, “The Theory and Practice of
Corporate Finance: Evidence from the Field,” Journal of Financial Economics, Vol. 60, nos. 2 and 3 (May–June 2001),
pp. 187–243, for the survey and Eugene F. Fama and Kenneth R. French, “Common Risk Factors in the Return on
Stocks and Bonds,” Journal of Financial Economics, 1993, pp. 3–56.
(^13) It is important to be consistent in the use of a long-term versus a short-term rate for r
RF and for the market risk
premium. The market risk premium (RPM! rM " rRF) depends on the measure used for the risk-free rate. The yield
curve is normally upward-sloping, so the 10-year Treasury bond rate normally exceeds the short-term Treasury
bill rate. In this case, it follows that one will obtain a lower estimate of the market risk premium if the higher
longer-term bond rate is used as the risk-free rate. At any rate, the rRF used to $ nd the market risk premium should
be the same as the rRF used as the $ rst term in the CAPM equation.