There are several good references to the capital-asset pricing model
on the Internet, including Wikipedia:
?Capital Asset Pricing Model,? (Sept. 15, 2005)
The CAPM model says that the return to investors (and to the
corporation, Rc) has to be equal to:
? the risk-free rate
? PLUS a premium for stocks as a whole that is higher than the
risk-free rate. This market return premium is (rM ? rf)
? And the market return should be multiplied by the risk factor for
the individual company, termed the ?beta of the corporation? (ßc)
Expressed as a formula, it?s:
Rc = rf + ßc(rM - rf)
Rc is the company's expected return on capital
rf is the risk-free return rate, usually a long-term U.S. Treasury bill rate
rM is the expected return on the entire market of all investments.
Most measures use a common broad index, most often the S&P500 over the
past 5 or 10 years
ßc is the company's Beta, based on its covariance with the market.
In the first scenario it is ?
Rc = 4.9% + 1.3 * 9.8% = 17.64%
In the second scenario it is:
Rc = 3.7% + 1.3 * 11 = 18%
There are many assumptions behind the CAPM you may want to note from
the Wikipedia link above. A critical assumption in this ? with a 1.2%
drop in the T-bill or risk-free rate ? is that market returns don?t
change. Often lower T-bill rates result in lower Rm numbers.
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Capital asset pricing model