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Cost of capital and capital investment decisions

The Capital Asset Pricing Model (CAPM)

5.1 Key elements of CAPM

 A methodology for measuring business risk.

 An equation for determining what level of required return is needed to
compensate for the measured level of risk.

5.2 Systematic and unsystematic risk

 As an investor increases the size of his/her portfolio, overall risk reduces.

Risk of

portfolio
(σ) Unsystematic
risk

Systematic
risk

Number of shares in portfolio

 If the investor has approximately 15–20 well-chosen shares in his portfolio, the
unsystematic risk will be eliminated and the investor is 'well-diversified'.

 Systematic risk is caused by general, macro-economic factors (e.g. recession,
interest rates, exchange rates). It cannot be diversified away.

 Unsystematic risk is caused by factors specific to the company or industry (e.g.
systems failure, R+D success, strikes).

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