2. Estimating the Cost of Equity

2.1. Using the CAPM

If we want to capitalize the cash flows expected from an investment in asset j, we need an estimate of the appropriate discount rate. According to the CAPM, this discount rate is:

 

\( k_j= R_F+MRP\times \beta_j \)

 

Therefore, to actually use the formula, we have to estimate:

 

\( R_F \)

the risk-free rate of return;

MRP

the market risk premium; and

\( \beta_j \)

the asset's beta.

 

The intuition behind this model is fairly straightforward. It decomposes the required rate of return into two parts: 

  • The risk-free rate of return: This rate indicates how much the investors can earn without taking any risk.
  • A risk premium: On top of the risk-free rate of return, the investors want to be compensated for the risk they take by investing in the asset in question. This risk premium, in turn, can be broken down into two elements: The amount of risk and the price of risk. 
    • Amount of risk: "Beta" indicates how risky the asset is compared to an investment in the market. A beta of 2, for example, implies that the asset is twice as risky as an investment in the market. In the Appendix to this chapter, we explain in more detail what "risk" actually means.
    • Price of risk: The Market Risk Premium (MRP) measures the risk premium investors expect to earn when investing in the market (that is, when assuming one unit of "risk").

 

Let's illustrate this with a simple example: Suppose the risk-free rate of return is 2% and the market risk premium is 6%. The asset you want to invest in has a "Beta" of 3, that is, it is three times as risky as an investment in the market. This information implies that investors will require a rate of return of 20% when investing in the asset:

 

\( k = R_F+MRP\times \beta = 0.02 + 0.06\times 3 = 0.20 \) = 20%.

 
In contrast, investors would only expect to earn a return of 8% when investing in the "market" (= 0.02 + 0.06*1) because such an investment would entail considerably lower risk.

 

The following sections take a closer look at how to estimate the risk-free rate of return, the market risk premium, as well as the beta of a stock.