The cost of equity

COST OF EQUITY

CAPITAL ASSET PRICING MODEL : The capital asset pricing model states that the theory of relationship between risk and return , which states that the expected risk premium on any security is equal to its beta times the market risk premium . The expected rate of return demanded by investors depend upon two things compensation of the time value of money (The risk free rate , T bill rate ) and a risk premium , which depends on beta and the market risk premium . CAPM model predict a very realistic approach to calculate the expected

rate of return for the investors who are holding stock for their required return . Many firms use this model because it is more accurate as compared to other models and also realistic in nature

The formula for CAPM model is stated as

R Rf B (Rm-Rf

Where Rf is risk free rate (T bill rate , B states beta on market return and Rm is return on market . This relationship in formula states that the investors should get a return on their stocks with calculation of risk free rate plus the risk they have incurred in holding the stocks . The rate should be above the risk free rate and also the return on market rate for the risk they have taken . The higher the risk the return on stocks would be higher . Even a little diversification can provide a substantial reduction in variability

Suppose you calculate and compare the standard deviations of randomly chosen

one-stock portfolios , two-stock portfolios , five-stock...