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The capital asset pricing model (CAPM) is used to calculate the required rate of return for
any risky asset. Your required rate of return is the increase in value you should expect to see
based on the inherent risk level of the asset
8. Also assume that investors are on general agreement and them likely performance of
individual securities and their expectations are based on a common holding period
one year.
There are two types of investment opportunities:
Risk Free security whose return over the holding period is known with
certainity.
Market portfolio of common stocks. It represented by all available common
stocks and weighted of their aggregate market value outstanding.
Bhandari (1988), concluded that the leverage variable, as a function of average returns, apart
from size and beta. High leverage increases the riskiness of a firms equity, but this increased
risk should be reflected in a higher beta coefficient.
Jegadeesh and Titman (1993) confirms these results. Their study also indicates that the
momentum is stronger for firms that have had poor recent performance
How to Calculate Beta
Beta is a measure used in fundamental analysis to determine the volatility of an asset or
portfolio in relation to the overall market. To calculate the beta of a security, the covariance
between the return of the security and the return of market must be known, as well as the
variance of the market returns.
The formula for calculating beta is the covariance of the return of an asset and the return of
the benchmark divided by the variance of the return of the benchmark over a certain period.
Beta= Covariance (ri,rm )/Variance of Market
Similarly beta can be calculated security's standard deviation of returns by the benchmark's
standard deviation of returns. The resulting value is multiplied by the correlation of the
security's returns and the benchmark's returns.
Beta= Correlation (ra,rm)* S.D(i)/ S.D(m)
rm: 12%
Using the dividend growth model, we can calculate that Company XYZ's Cost of Capital is
($1 / $10 ) + 3% = 13%
Using CAPM, we can calculate that Company XYZ's cost of capital is 3% + 1.0*(12% - 3%)
= 12%