Introduction to Corporate Finance

7: Risk, Return and the Capital Asset Pricing Model

The CAPM stands as one of the most important ideas in all of finance. Financial managers in nearly

all large corporations know the model’s key predictions, and they use the CAPM to estimate the rate

of return that shareholders require on the company’s shares. Managers use the required return on their

company’s shares (along with other information) to calculate the company’s weighted average cost of

capital (WACC). The WACC is important because most companies only make new investments when

they believe those investments will earn returns that exceed the WACC.

As useful as it is, however, the CAPM is not a crystal ball. It gives us some insights about expected

returns, but that is not the same thing as predicting how the future will unfold. In the next section, we

explore the extent to which actual share returns, rather than expected returns, may be predictable.

See the concept explained

step by step on the

CourseMate website.

SMART

CONCEPTS

12 See Giang Truong, Graham Partington and Maurice Peat, ‘Cost-of-Capital Estimation and Capital-Budgeting Practice in Australia’, Australian
Journal of Management, June 2008, Vol. 33, No 1; ABI/INFORM Global, p. 95.

finance in practice

DO COMPANIES USE THE CAPM?

Graham and Harvey (2001) asked nearly 400 CFOs

about the method they used to determine the cost

of equity for their companies. As the accompanying

chart indicates, nearly three-quarters of respondents

said that their companies almost always or always

(responses 3 and 4 in the survey) used the CAPM to

determine the return that the market required on

their shares. The second-mostcommon method for

estimating the cost of equity – using the historical

average return – was used by roughly half as many

CFOs.

The survey results suggested that the use of

CAPM was widespread in companies around the

world, although the model’s popularity was not

as strong outside the US. In the UK and France,

roughly 45% of CFOs said their companies used the

CAPM, whereas closer to one-third of German CFOs

reported doing so. However, this pattern is changing

over time. The percentage of companies using the

CAPM has been rising for years in the United States,

and that trend seems likely to continue abroad. The

market in Australia seems to mirror the United States.

A survey of listed company CFOs, conducted in

Australia in 2004 by Truong, Partington and Peat,^12

found that 72% of respondents used the CAPM to

estimate their cost of capital.

How would you estimate the

rate of return that a company’s

shareholders expect from the

company’s shares?

thinking cap

question

How often do you use the CAPM to calculate the cost of equity?

0

20

40

60

0 = Never 1 = Sometimes 2 = Half the time 3 = Most of the time 4 = Always

Percentage of CFOs responding