Applying the Capital Asset Pricing Model

Abstract

This note discusses how some of the most financially sophisticated companies and financial advisors estimate the cost of equity capital. It focuses on areas where finance theory is silent or ambiguous and practitioners are left to their own devices. Survey evidence shows that the Capital Asset Pricing Model (CAPM) is the most widely used model. The note discusses methods companies use to estimate the three key elements needed to apply the CAPM: a proxy for the risk-free rate, an estimate of beta, and an equity-market risk premium. The note is useful for students attempting to apply the Capital Asset Pricing Model.

Excerpt

UVA-F-1456

Rev. Apr. 8, 2014

APPLYING THE CAPITAL ASSET PRICING MODEL

This note discusses how some of the most financially sophisticated companies and financial advisers estimate the cost of equity capital. We particularly focus on areas where finance theory is silent or ambiguous, and practitioners are left to their own devices.

Conclusions are based on interviews with two groups: (1) well-regarded firms ranked by peer companies as industry leaders and (2) a sample of 11 of the most active financial advisers (investment banks). For context on academic advice, we also cite recommendations from top-selling graduate-level textbooks and trade books in corporate finance.

Findings

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Keywords: capital asset pricing, cost of capital, risk-free rate of return, beta estimates