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The cost of capital

The CAPM formula and the beta factor

E(r j) = R f + β i[E(r m) – R f ]

Where:

ß i = the entity’s ‘beta factor’ – a measure of the systematic risk of
investment i relative to the market

N.B. It is assumed that investors are well diversified

E(r j) = required rate of return of the investor (equivalent to k e)
R f = risk-free rate of return

E(r m) = expected average return on the market (shortened to R m)

E(r m) – R f = equity risk 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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