Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 10

Capital Asset Pricing Model

Introduction

Concept of Market or Systematic Risk

Background of the Capital Asset Pricing Model

Market (or Systematic) and Unique (or Unsystematic) Risks

Using Beta to Estimate Expected Rate of Return

Modifying CAPM

Firm Size Phenomenon

Company-specific Risk Factor

Modified CAPM Cost of Capital Formula

Examples of a CAPM Model

Example of CAPM Method Using Morningstar Data

Example of a CAPM Method Using Duff & Phelps Size Study Data

Assumptions Underlying the Capital Asset Pricing Model

Summary

INTRODUCTION

The capital asset pricing model (CAPM) has served as the foundation for pricing risk for nearly fifty years. One author has summarized its acceptance this way:

Modern academic finance is built on the proposition that markets are fundamentally rational. The foundational model of market rationality is the CAPM. The implications of rejecting market rationality as encapsulated by the CAPM are very considerable. In capturing the idea that markets are inherently rational, the CAPM has made finance an appropriate subject for econometric studies. Industry has come to reply on the CAPM for determining the discount rate for valuing investments within the firm, for valuing the firm itself, and for setting sales prices in the regulation of utilities, as well as for such purposes as benchmarking fund managers and setting executive bonuses linked to adding economic value.¹

Financial theorists generally have favored using the CAPM as the preferred ...