Topic
The capital asset pricing model
Instructions
- Explain how the risk-free rate, market risk premium, and stock beta are used to calculate expected returns using the capital asset pricing model (CAPM).
- Explain how cyclicality of revenues and operating leverage help determine beta.
- Describe the dividend discount model (DDM) approach and how is it different than CAPM.
- Understand how to calculate the weighted average cost of capital to determine the optimum level of debt and equity to finance an investment.
Answer Preview
The capital asset pricing model is a model that explains the relationship between risk and expected returns for assets for the given stock. It’s the most popular method for pricing risky securities. In its computation, the method looks at the time value of money and the risk behind the investment. The formulae followed is: -, whereby
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