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CAPM

The Capital Asset Pricing Model (CAPM) explains the relationship between risk and expected return, helping to price securities and calculate the cost of equity. Two examples illustrate how to compute the cost of equity using beta, the expected market return, and the risk-free rate. In the examples, the cost of equity for Msula Ltd is calculated as 9.4% and for Msula it is determined to be 11% based on given parameters.

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2 views7 pages

CAPM

The Capital Asset Pricing Model (CAPM) explains the relationship between risk and expected return, helping to price securities and calculate the cost of equity. Two examples illustrate how to compute the cost of equity using beta, the expected market return, and the risk-free rate. In the examples, the cost of equity for Msula Ltd is calculated as 9.4% and for Msula it is determined to be 11% based on given parameters.

Uploaded by

spencerstrasmo
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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CAPITAL ASSET PRICING MODEL - CAPM

 The model incorporate risk and shows its relationship to the


expected return. It is used in pricing securities. Basically
CAPM considered that investors need to be compensated
for investing their cash
 CAPM is used to calculate the cost of ordinary shares
(Equity)
EXAMPLE 1
Shares in Msula Ltd have a beta of 0.9. The expected return on the market is 10%
and risk free rate of return is 4%. Calculate the cost of equity for Msula.
Ke = 4 + 0.9(10 – 4)
= 9.4%

EXAMPLE 2
Investors expect a rate of return of 8% from Ordinary shares in Msunsa, which
have a beta of 1.2. Expected return on the market is 7%. What will be the
expected rate of return from ordinary shares in Msula which have a beta of 1.8?
Msunsa
8% = Rf + 1.2 (7% - Rf)
8 = Rf + 8.4 -1.2Rf
Rf = 2

Msula
Ke = Rf + Beta( Rm – Rf)
= 2 + 1.8 ( 7- 2)
= 11%

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