(c) CAPM and risk
The capital asset pricing model (CAPM) provides an alternative to the dividend valuation model as a
method of calculating the cost of equity. Unlike the dividend valuation model, the CAPM seeks to
differentiate between the various types of risk faced by a firm and to allow for the fact that new
projects undertaken may carry a different level of risk from the existing business.
Beta factors
The model focuses on the level of systematic risk attaching to the firm, in other words, that element
of risk which is common to all investments and which cannot be avoided by diversification.
The model uses the beta factor as a measure of an individual share's volatility of expected returns as
against the market average. A beta factor of less than 1.0 indicates that the expected volatility is less
than that of the market as a whole, and more than 1 vice versa.
The model can be formulated as follows:
Thus the additional information that would be required is as follows.
Beta factor
This can be calculated statistically from historical records of:
(i) The returns earned by the share in terms of capital gains/losses and dividends
(ii) The overall returns earned by the market.
Market rate of return
This is the average annual rate of return on the securities market as a whole. This can be calculated
from historical records.
Risk-free rate of return
This is generally taken to be the rate of return on government stocks.
