Further, WACC itself is found widespread application, that includes financial modeling, calculation of net present value by discounting the future cash flows, determination of enterprise value and equity value.Required Rate of Return Capital Asset Pricing Model (CAPM) One of its primary application includes calculation of the cost of equity which is eventually used in the calculation of the weighted average cost of capital (WACC). R e= R f + β * (R m – R f) Relevance and Uses of Capital Asset Pricing Model Formulaįrom the perspective of a financial analyst, it is important to understand the concept of capital asset pricing model as it has extensive application in the finance industry. Step 5: Finally, the formula for CAPM can be derived by adding the risk-free rate of return (step 1) to the product of beta of the security (step 4) and market risk premium (step 3) as shown below. Basically, it is the measure of the volatility of the stock’s returns which is computed by evaluating its price fluctuation vis-à-vis the movement witnessed in the overall market.
Step 4: Next, determine the beta of the security based on its relative movement with respect to the market or any benchmark index. It can be seen as the surplus return expected by the investor over and above the risk-free rate in order to be compensated for investing in the relatively riskier security. Step 3: Next, calculate the market risk premium for the security by deducting the risk-free rate of return (step 1) from the rate of return expected from the market (step 2). Step 2: Next, determine the rate of return expected in the broader market based on certain benchmark which can be the stock market index. Typically return earned on government securities or Treasury bills are used as a proxy for the risk-free rate of return as these securities are considered to have the minimum risk. Step 1: Firstly, determine the risk-free rate of return prevalent in the market. The formula for CAPM can be derived by using the following steps: Therefore, the investment has generated an adequate return to beat the expected rate of return. Expected Rate of Return= 4.5% + 1.2 * (8.0% – 4.5%)īased on the capital asset pricing model and given risk level of the stocks, the expected rate of return of the stocks is 8.7%, while the investor has realized an actual return of 9.0%.Help the investor to calculate the expected rate of return based on the capital asset pricing model.
The investor wants to evaluate whether the stock generated adequate return given its risk level. The stocks purchased have a beta of 1.2 when compared to the market, i.e. The relevant 10-year treasury bills are trading at 4.5% per annum. During that period, the overall market has grown by 8%, while the stock purchased by him has generated a return of 9%. Let us take another example where the investor had purchased in some stocks one year back. Capital Asset Pricing Model Formula – Example #2
Now, he came to realize that the market is currently expected to generate a return of 7% during the next year, while the 10-year treasury bills are trading at 4% per annum. Let us take the example of Phil who has recently purchased stocks worth $5,000.
You can download this Capital Asset Pricing Model Formula Excel Template here – Capital Asset Pricing Model Formula Excel Template Capital Asset Pricing Model Formula – Example #1