Principles of Managerial Finance

Using the Capital Asset Pricing Model (CAPM)

Recall from Chapter 5 that the capital asset pricing model (CAPM)describes the

relationship between the required return, ks, and the nondiversifiable risk of the

firm as measured by the beta coefficient, b.The basic CAPM is

ksRF[b(kmRF)] (11.6)

where

RFrisk-free rate of return

kmmarket return; return on the market portfolio of assets

Using CAPM indicates that the cost of common stock equity is the return

required by investors as compensation for the firm’s nondiversifiable risk, mea-

sured by beta.

EXAMPLE Duchess Corporation now wishes to calculate its cost of common stock equity,

ks, by using the capital asset pricing model. The firm’s investment advisers and

its own analyses indicate that the risk-free rate,RF, equals 7%; the firm’s beta,

b,equals 1.5; and the market return,km, equals 11%. Substituting these values

into Equation 11.6, the company estimates the cost of common stock equity,ks,

to be

ks7.0%[1.5(11.0%7.0%)]7.0%6.0% 1



3



.



0



%

The 13.0% cost of common stock equity represents the required return of investors

in Duchess Corporation common stock. It is the same as that found by using the

constant-growth valuation model.

Comparing the Constant-Growth and CAPM Techniques

The CAPM technique differs from the constant-growth valuation model in that it

directly considers the firm’s risk, as reflected by beta, in determining therequired

return or cost of common stock equity. The constant-growth model does not look

at risk; it uses the market price,P 0 , as a reflection of theexpectedrisk–return pref-

erence of investors in the marketplace. The constant-growth valuation and

CAPM techniques for findingksare theoretically equivalent. But it is difficult to

demonstrate that equivalency because of measurement problems associated with

growth, beta, the risk-free rate (what maturity of government security to use), and

the market return. The use of the constant-growth valuation model is often pre-

ferred because the data required are more readily available.

Another difference is that when the constant-growth valuation model is used

to find the cost of common stock equity, it can easily be adjusted for flotation

costs to find the cost of new common stock; the CAPM does not provide a simple

adjustment mechanism. The difficulty in adjusting the cost of common stock

equity calculated by using CAPM occurs because in its common form the model

does not include the market price, P 0 , a variable needed to make such an adjust-

ment. Although CAPM has a stronger theoretical foundation, the computational

appeal of the traditional constant-growth valuation model justifies its use

throughout this text to measure common stock costs.

CHAPTER 11 The Cost of Capital 479

capital asset pricing model
(CAPM)
Describes the relationship
between the required return, ks,
and the nondiversifiable risk of
the firm as measured by the beta
coefficient, b.