What does the CAPM formula calculate?

What does the CAPM formula calculate?

• A. Cost of equity only
• B. Risk-free rate + beta (market return - risk-free rate)
• C. Average cost of debt
• D. Risk premium over cash investments

Answer: (B)

The Capital Asset Pricing Model (CAPM) formula specifically calculates the expected return on an investment based on its risk relative to the market. It reflects the relationship between systematic risk, represented by beta, and expected return. The formula can be expressed as: Expected Return = Risk-free rate + Beta × (Market Return - Risk-free rate). In this context, the risk-free rate is the return on an investment with zero risk, and the term (Market Return - Risk-free rate) represents the market risk premium, which compensates investors for taking on the additional risk associated with stock investments compared to a risk-free asset. By multiplying the beta by this market risk premium, the CAPM adjusts the expected return based on the investment's sensitivity to overall market movements. This makes the second choice a comprehensive representation of what the CAPM formula calculates. The other options provided do not capture the comprehensive nature of the CAPM formula. For instance, while cost of equity is certainly one aspect of what the CAPM can derive, the formula is broader and includes market factors. Similarly, average cost of debt and risk premium over cash investments are not factors included in the formula itself, which specifically ties the expected return to market performance and systematic risk through beta.

The Capital Asset Pricing Model (CAPM) formula specifically calculates the expected return on an investment based on its risk relative to the market. It reflects the relationship between systematic risk, represented by beta, and expected return. The formula can be expressed as:

Expected Return = Risk-free rate + Beta × (Market Return - Risk-free rate).

In this context, the risk-free rate is the return on an investment with zero risk, and the term (Market Return - Risk-free rate) represents the market risk premium, which compensates investors for taking on the additional risk associated with stock investments compared to a risk-free asset. By multiplying the beta by this market risk premium, the CAPM adjusts the expected return based on the investment's sensitivity to overall market movements. This makes the second choice a comprehensive representation of what the CAPM formula calculates.

The other options provided do not capture the comprehensive nature of the CAPM formula. For instance, while cost of equity is certainly one aspect of what the CAPM can derive, the formula is broader and includes market factors. Similarly, average cost of debt and risk premium over cash investments are not factors included in the formula itself, which specifically ties the expected return to market performance and systematic risk through beta.