AFMP4
Syllabus B3cd. The Cost of CapitalCost of equity

capm 2 / 5

CAPM

This method also calculates the cost of equity (like dvm) but looks more closely at the shareholder’s rate of return, in terms of risk.

The more risk a shareholder takes, the more return he will want, so the cost of equity will increase.

For example, a shareholder looking at a new investment in a different business area may have a different risk.

The model assumes a well diversified (see later) investor.

It suggests that any investor would at least want the same return return that they could get from a “risk free” investment such as government bonds (Greece?!!).

This is called the risk free return

On top of the risk free return, they would also want a return to reflect the extra risk they are taking by investing in a market share.

They may want a return higher or lower than the average market return depending on whether the share they are investing in has a higher or lower risk than the average market risk

The average market premium is Market return - Risk free return

The higher or lower requirement compared to the average market premium is called the beta (β)

Required Return = Rf + β(Rm - Rf)

  • Rm = Average return for the whole market
    Rm - Rf = Average market risk premium
    Beta (β )= How much of the average market risk premium (Rm - Rf) is needed

Systematic and non-systematic risk

More technically Beta (β ) = Systematic risk of the investment compared to the market

  1. Systematic risk

    Market wide risk - such as state of the economy

    All companies, though, do not have the same systematic risk as some are affected more or less than others by external economic factors

  2. Non Systematic Risk

    Risk that is unique to a certain asset or company. 

    An example of nonsystematic risk is the possibility of poor earnings or a strike amongst a company’s employees.

Non-systematic risk can be diversified away

  • One may mitigate nonsystematic risk by buying different securities in the same industry or different industries. 

    For example, a particular oil company has the diversifiable risk that it may drill little or no oil in a given year. 

    An investor may mitigate this risk by investing in several different oil companies as well as in companies having nothing to do with oil.

    Nonsystematic risk is also called diversifiable risk.

An explanation of the graph

  • If you have 1 share and this share does badly, then you DO BADLY.

  • If you have 10 shares and 1 share does badly, you are sad about 1 share, but you are still HAPPY about the other 9.

  • Therefore with 1 share you are taking more risk than if you have more shares.

    This risk is called UNSYSTEMATIC RISK

  • So, we can buy more shares and therefore the UNSYSTEMATIC RISK should GET SMALLER

  • You will be always left with some risk that can't be diversified away.

    This risk is called SYSTEMATIC RISK.

    It is BETA (β) in the CAPM formulae