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Chapter 10
The CAPM formula and the beta factor
k = R f + [R m – R f ] ß
where
ß = the entity’s ‘beta factor’ – a measure of the systematic risk of the entity
relative to the market
N.B. It is assumed that investors are well diversified
k = required rate of return of the investor
R f = risk-free rate of interest
R m = return on market portfolio
R m – R f = market premium
ß = 1 is the average for the market
Theory: The CAPM gives a required return for a given level of
systematic risk.
Therefore, if we can estimate the level of risk associated with an
entity (the beta of the entity), we can use CAPM to give a required
return to shareholders.
This required return to shareholders is essentially the cost of equity
which can then be used to derive an appropriate WACC for the
entity.
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