Capital Asset Pricing Model (CAPM)
CAPM is a methods that is used to establish the required rate of return of an investment provided a particular level of risk. According to CAPM, the total business risk of the firm can be divided into two:
Systematic Risk - This is the risk that affects all the firms in such market. This risk cannot be eliminated/diversified. Thus it is called undiversifiable risk. Because it affects all the firms in the market, the share price and profitability of the firms will be moving in the same direction that is systematically. Like examples of systematic risk are political instability, inflation, power crisis in the economy, natural calamities, power rationing - floods and earthquakes increase in corporate tax rates and personal tax rates so on. Systematic risk is measured via a Beta factor.
Unsystematic risk - This risk affects only one firm in the market however not other firms. Therefore it is unique to the firm thus unsystematic trend in profitability of the firm relative to the profitability trend of another firm in the market. The risk is caused with factors unique to the firm such as:
- Labour strikes via staff of the firm;
- Exit of a prominent corporate personality;
- Collapse of marketing and advertising programs of the firm on launching of a new product;
- Failure to make a research and development breakthrough by the firm, etc
CAPM is only concerned along with systematic risk. According to the model, the necessary rate of return will be highly influenced via the Beta factor of each investment. It is in addition to the excess returns an investor derives via undertaking additional risk as like cost of equity should be equal to Rf + (Rm - Rf)BE
Cost of debt = Rf + (Rm - Rf)Bd
Where: Rf = rate of return/interest rate on riskless investment e.g T. bills
Rm= Average rate of return for the entire stock as shown by average
Percentage return of the firms that constitute the stock index.
Be = Beta factor of investment in ordinary shares/equity.
Bd = Beta factor for investment in debentures/long term debt capital.