Capital Asset Pricing Model

The underlying theory and real world application of the Capital Asset Pricing Model (CAPM) is important, especially when evaluating alternative assets. CAPM, a formula to calculate the risk premium and expected return for a company, is one of the foundations of corporate finance. Investors use CAPM to estimate the anticipated risk and return on an equity holding or on a portfolio of equities. CAPM assumes there is a reward for risk, called an asset’s risk premium. To calculate an asset’s risk premium, multiply its beta by the market risk premium. The expected return on an asset equals the risk-free rate plus the risk premium. CAPM estimation of the cost of equity can be a component in the kind of discounted cash flow valuation analysis that is often conducted prior to a merger, acquisition, divestiture or restructuring.