11.3 The cost of equity using the capital asset pricing model

Question 1

What is the cost of equity?

Answer 1

The return investors expect to make on their shares in the company.

Question 2

What are the two models for determining the cost of equity?

Answer 2

1 The capital asset pricing model (CAPM)

2 The dividend valuation model

Question 3

Who developed the capital asset pricing model?

Answer 3

Sharpe (1964) and Lintner (1965)

Question 4

What is meant by “RADR” under the capital asset pricing model?

Answer 4

Risk-adjusted discount rate

Question 5

What is the risk-adjusted discount rate in the capital asset pricing model?

Answer 5

The rate used to discount a risky asset or investment such as real estate. It is the required periodical returns by investors to account for the higher risk involved. Cash flows from riskier assets will be discounted at a higher rate.

Question 6

What is the calculation for the risk-adjusted discount rate (RADR) in the capital asset pricing model?

Answer 6

RADR = risk-free rate (e.g. LIBOR) + risk premium

Question 7

There are two types of risk. What are they?

Answer 7

1 Systematic

2 Unsystematic

Question 8

What are unsystematic risks?

Answer 8

Risk factors specific to a particular company or industry . These can be eliminated by holding a large portfolio of diverse shares.

Question 9

Roughly how many different shares are required to cancel out unsystematic risk?

Answer 9

15-20 shares

Question 10

What are systematic risks (aka market risk?

Answer 10

Risk caused by macroeconomic factors which impacts all shares in the market.

Question 11

Beta (β) is the statistically derived risk premium of an investment. Using this β, what is the calculation for risk-adjusted discount rate?

Answer 11

RADR = RFR+ β(RM-RFR)

Where:
RFR = Risk free rate
RM = return on stock market portfolio

Question 12

What assumptions are made in the capital asset pricing model (CAPM)?

Answer 12

• investors are rational and possess full knowledge of the market
• investors expect greater returns for taking greater risks
• it is possible for an investor to diversify unsystematic risk
• borrowing and lending rates are equal
• there are no transaction costs
• markets are perfect and imperfections are self-correcting in the long run
• the RFR is the same as the returns on government bonds
• there is no taxation or inflation

Question 13

What are the criticisms of the capital asset pricing model (CAPM)?

Answer 13

• factors other than β, such as company size, market value etc, can also affect excess returns. CAPM does not consider these
• systematic risk and β can be difficult to determine
• companies with multiple business divisions may have different systematic risks for each division
• CAPM is only relevant for one year