CAPM
There are several different models that can be used to help determine the cost of capital for a company. Each is based on a model, and can be understood not only in terms of its formula but also in terms of its underlying assumptions. These assumptions will provide the foundation for the model, and will inform the financial manager about the strengths and weaknesses of each model. This report will outline in detail three such major models for determining the cost of capital. The first is the capital asset pricing model, known as CAPM. The second is the dividend discount model, and the third is arbitrage pricing theory.
The capital asset pricing model is the first of the three major models for determining the cost of capital. CAPM is widely used to determine the cost of equity in particular. The underlying theory of CAPM is that stock returns relative to risk can be used to determine what cost the market needs for that equity. In short, "investors need to be compensated in two ways: time value of money and risk" (Investopedia, 2013). Thus, the return on a security equates to the risk-free rate of money in the economy, plus a risk premium. The risk premium in the capital asset pricing model is comprised of two elements. The first is the general market risk premium, which is the risk of the market in general above and beyond the risk-free rate. The second component of risk in the capital asset pricing model is the firm-specific risk. For equities, the firm-specific risk is reflected in the beta. The beta is the correlation of the firm's stock price movements in relation to the movements of the market as a whole. Thus, the formula for the capital asset pricing model is as follows:
Source: Investopedia (2013)
The capital asset pricing model is easy to use, because all of the information inputs into the model are easy to come by. The risk free rate is the rate of return on Treasury securities, and the market risk premium is often considered to be around 7% above the risk-free rate. The beta is easy to calculate on a spreadsheet and indeed for all publicly-traded securities is available from any number of financial...
CAPM There are three different models for estimating the cost of capital -- the capital asset pricing model (CAPM), dividend discount model and arbitrage pricing theory (APT). Of these, CAPM is the best model. CAPM utilizes the returns on the company's stock to calculate the firm's cost of equity. The underlying theory is that the firm's cost of capital should "equal the rate on a risk-free security plus a risk premium"
CAPM The first scenario represents a diversifiable risk. The rate of inflation has an effect on the whole economy, but the nature and direction of that effect is something that will be different for each firm. Some firms may suffer more than others from the effects of a higher rate of inflation, depending on their business model, their capital structure and their strategy. In addition, inflation rates are a national phenomenon.
CAPM There are three models that can be used calculate the cost of capital for the firm. The first such model is the capital asset pricing model (CAPM). The CAPM formula is: E (rj )= RRF + b (RM - RRF). This means that the company's cost of capital is a function of the risk free rate, the market premium and the firm-specific risk. In CAPM, the firm-specific risk is based
RISK Management - CAPM and APT Capital Asset Pricing Model and Arbitrage Pricing Theory The contemporaneous business community is extremely competitive, meaning as such that the organizational leaders strive harder than ever to overcome the competitive forces. Virtually, they have to hire and retain the best skilled staff members; they have to develop and offer the best quality products and services and they must be able to raise the interest of a
Finance There are three different models that can be used to estimate a company's cost of capital. Basically, each of these three is used to estimate the cost of equity. The cost of debt is usually calculated on the basis of the current weighted average of the yield to maturity on the company's debt. Thus, it is the cost of equity that must be calculated. The cost of equity reflects the
Approximately 19% of the short-term liabilities in the form of notes payable and other short-term debt. The long-term liabilities consist of long-term debt and other miscellaneous liabilities. The debt portion of this represents approximately 39% of the total long-term liabilities. Johnson & Johnson has issued notes onto the market that mature in 2017, comprising the bulk of the long-term debt. The calculate the market value capital structure of JNJ, we need
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