Hello,

Can anyone please explain me the Cost of Equity CAPM model.

Your help will be highly appreciated.

Regards,
Ayesha Jabeen.

Dear Ayesha,

Cost of Equity is simply the cost which the company has to bear for example if the company wants to arrange finance through issuance of shares then it has to pay dividends in future, similarly if the company wants to issue debentures then it has to pay interest on that loan.

Unfortunately in our course of F9(Financial Management) ACCA has not yet introduced the full derivation of the Beta of CAPM but this was the part of previous 3.7 curriculum however for the sake of concept i will explain it to you in details as well as with full derivation.

What is CAPM?
Capital Asset Pricing Model is the model that describes the relationship between risk and return the higher the risk the higher the return, in this model a security's(Investment) expected return is the risk free rate plus a premium based on the systematic risk of the security.

The Total Risk Of a Portfolio(see note 1) consists of two types of risks, Systematic and Un-Systematic risk, if we have lage enough portfolio it is possible for us to eleminate the unsystematic risk, however the systematic risk will always exist.

Note 1:A portfolio is like a wallet in which you can have more than 1 security or investment for exampl i have invested in 5 different companies with differing and varied industries so this shows that my portfolio size is 5.

now, first you need to have the full knowledge of Systematic and Unsystematic risk.

Unsystematic Risk:-

It is also called specific risk this risk is the risk that the occurance of it will only affect one company or one industry or one security fro example industrial relations problems, seasonal variations for example i have invested in the company making Ice Creams there is an unsyatematic risk that when particular season is over the share prices of this company may fall so this unsystematic risk can be avoided by investing in counter industry for example in a company making cofee or other similar products so it is highly likely that when share prices of Ice Creams and related product company will fall the prices of Cofee and similar products company will rises this will reduce the unsystematic risk.

This risk can be avoided by incereasing the size of portfolio i.e investing in different industries and varied companies.

Systematic Risk:-

It is also known as Market Risk, this risk is unavoidable for whole market and will affect every industry and every company these are macro or general economic factors and these include, country's rate of economic growth for example declining economy, corporate tax rates for example increasing tax rates and loss of treties,increasing interest rates and so on.

These factors are same for whole market and thus, these are unavoidable factors

now, re-read this definition of CAPM "Capital Asset Pricing Model is the model that describes the relationship between risk and return the higher the risk the higher the return, in this model a security's(Investment) expected return is the risk free rate plus a premium based on the systematic risk of the security."


So,

Required Rate Of Return==>Rf+(Rm-Rf)*Beta

Rf=>Risk Free rate of return(often therate quoted by banks)
Rm=>Market Return on security

So, in the evaluation procedure of a security we will put the numbers in above formlate to derive Required rate ofreturn and if the security is quoted at higher return we will be consider this to adopt as our new investment.

this is very basic concept of CAPM this formula of Required return came from certain derivations which is unfortunately out of our F9 curriculum but if you are interested in full derivation i will be post its derivation.

Regards,

Muhammad Amir

Hello Amir,

Thanks for your help.
I am still not sure about this "a security's(Investment) expected return is the risk free rate plus a premium based on the systematic risk of the security"

Could you kindly elaborate it.And how would you differentiate with DVM model.
And I don`t need the derivation as I will study that in Advance paper.

Thanks.
Regards,
Ayesha Jabeen.

DVM didnt take into account of risk.

CAPM take into account of risk.

Dear Ayesha,

"a security's(Investment) expected return is the risk free rate plus a premium based on the systematic risk of the security".

It means that if you are going to invest in a security, you need to evaluate it that whether it will be lucrative in future and that the returns given by a security are those that are expected by you.

Thus, the security's expected return is Risk Free Rate Of Return(usually bank's interest rate or governmental security's rate of return) plusa premium based on systematic risk.

I have already illustrated the difference between Systematic Risk and Un-Systematic Risk, this systematic risk is the risk that affects whole market for example raising interest rates, declining economy, increasing inflation etc.

UnSystematic Risk is the risk that is specific to one industry to one sector and can be eliminated by diversification(diversifying means that a risk averse investor maintain a huge portfolio of more than one security and if the returns from one sector starts declining it will be hopeful that returns from other security will compensate the loss from other one).

So the The expected return is Risk Free Rate plus the the premium based on syatematic risk involved in security.

Total Risk=èSystematic Risk(non diversifiable or unavoidable) + Un-Systematic Riask(diversifiable or avoidable)

So we can avoid the Un-Systematic Risk through diversification but we can’t eliminate the Systematic risk because of this potential investor will seek the return on the risk that is unavoidable.

Remember that CAPM assumes that investors are risk averse and therefore they maintain well diversified portfolio due to this reason CAPM assumes that Un-Systematic risk is zero.


Difference between CAPM and DVM:-
==>CAPM directly considers risk, as reflected by beta, in determining the cost of capital.

==>DVM does not look at risk directly, but uses the market price, as a reflection of the expected risk-return preference of investors.

==>DVM approach more often used as required data is more readily available.


==>CAPM is one period model.

Regards,

Muhammad Amir

Hello,

Thanks alot Amir.

Regards,
Ayesha Jabeen.