Page 335 - Microsoft Word - 00 ACCA F9 IWB prelims 2017.docx

The cost of capital

Estimating the cost of equity – the

capital asset pricing model (CAPM)

The CAPM enables us to calculate the required return from an
investment given the level of risk associated with the investment
(measured by its beta factor).

Before showing how the CAPM formula can be used to derive a suitable
risk adjusted cost of capital for discounting, we first need to introduce
the model and explain the terminology surrounding it.

In order to explain how the CAPM works, it is first necessary to
introduce the concepts of systematic and unsystematic risk.

2 types of risk

Systematic risk Unsystematic risk

Caused by general, macro- Caused by factors specific to
economic factors the company or industry
(e.g. recession, interest rates, (e.g. systems failure, R+D
exchange rates) success. strikes)

327