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CAPM

The document discusses the Capital Asset Pricing Model (CAPM) and its significance in calculating the weighted average cost of capital (WACC), which is essential for financial modeling and determining investment values. It explains the CAPM formula, which calculates expected returns based on systematic risk and includes concepts like risk premium and beta. Additionally, it introduces the Capital Market Line (CML), illustrating optimal risk-return combinations and its relationship with the efficient frontier.

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Vijay Singh Kumar Vijay
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25 views6 pages

CAPM

The document discusses the Capital Asset Pricing Model (CAPM) and its significance in calculating the weighted average cost of capital (WACC), which is essential for financial modeling and determining investment values. It explains the CAPM formula, which calculates expected returns based on systematic risk and includes concepts like risk premium and beta. Additionally, it introduces the Capital Market Line (CML), illustrating optimal risk-return combinations and its relationship with the efficient frontier.

Uploaded by

Vijay Singh Kumar Vijay
Copyright
© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
Available Formats
Download as PPTX, PDF, TXT or read online on Scribd

The CAPM formula is widely used in the finance industry.

It is
vital in calculating the weighted average cost of capital
(WACC), as CAPM computes the cost of equity.

WACC is used extensively in financial modeling. It can be used


to find the net present value (NPV) of the future cash flows of
an investment and to further calculate its enterprise value and
finally its equity value.
CAPM Formula and Calculation

CAPM is calculated according to the • The CAPM formula is used for


calculating the expected returns of an
following formula: asset. It is based on the idea of
systematic risk (otherwise known as
CAPM Formula non-diversifiable risk) that investors
need to be compensated for in the form
Where: of a risk premium.
Ra = Expected return on a security
Rrf = Risk-free rate • A risk premium is a rate of return
greater than the risk-free rate. When
Ba = Beta of the security investing, investors desire a higher risk
premium when taking on more risky
Rm = Expected return of the investments.
marketNote: “Risk Premium” = (Rm – Rrf)
Capital Market Line

• Capital Market Line

• Capital Market Line (CML) Definition

• The Capital Market Line is a graphical representation of all the portfolios that optimally combine

risk and return. CML is a theoretical concept that gives optimal combinations of a risk-free asset

and the market portfolio. The CML is superior to Efficient Frontier in the sense that it combines the

risky assets with the risk-free asset.


Capital Market Line
 The slope of the Capital Market Line(CML) is the

Sharpe Ratio of the market portfolio.

 The efficient frontier represents combinations of risky assets.

 If we draw a line from the risk-free rate of return which is

tangential to the efficient frontier, we get the Capital Market

Line. The point of tangency is the most efficient portfolio.

 Moving up the CML will increase the risk of the portfolio and

moving down will decrease the risk. Subsequently, the

return expectation will also increase or decrease respectively.


Capital Asset Pricing Model
• Beta CAPM - Beta

• The beta (denoted as “Ba” in the CAPM


formula) is a measure of a stock’s risk
(volatility of returns) reflected by measuring
the fluctuation of its price changes relative to
the overall market. In other words, it is the
stock’s sensitivity to market risk. For
instance, if a company’s beta is equal to 1.5
the security has 150% of the volatility of the
market average. However, if the beta is equal
to 1, the expected return on a security is
equal to the average market return. A beta of
-1 means security has a perfect negative
correlation with the market.

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