CAPM Calculator
Calculate expected rate of return (R_e) and cost of equity using the Capital Asset Pricing Model (CAPM) based on stock Beta and market risk premiums.
Calculate Cost of Equity (CAPM Model)
Enter risk-free rate %, stock Beta ($\beta$), and expected market return %.
CAPM Output
Quick Summary
Our CAPM calculator capital asset pricing model cost of equity calculates the required rate of return for an equity investment or individual stock. By evaluating the Risk-Free Rate ($R_f$), Market Risk Premium ($R_m - R_f$), and stock Beta ($\beta$), this tool determines the exact Cost of Equity ($R_e$) input required for WACC and DCF valuation models.
How It Works: Capital Asset Pricing Model (CAPM)
CAPM calculates expected return by adding a risk premium to the risk-free rate based on systematic volatility.
1. **Risk-Free Rate ($R_f$):** Guaranteed return on default-free government bonds (10-Year US Treasury).
2. **Market Risk Premium ($ERP = R_m - R_f$):** Additional return expected from investing in the overall stock market (S&P 500) over risk-free bonds.
3. **Stock Beta ($\beta$):** Measures systematic risk. $\beta = 1.0$ matches market volatility, $\beta > 1.0$ indicates higher volatility, and $\beta < 1.0$ indicates defensive low volatility.
Formula Explanation
Your Expected Cost of Equity ($R_e$) and Equity Risk Premium ($ERP$) are calculated as follows:
Step-by-Step Worked Example
Here is a detailed 5-step breakdown for a stock with a 4.00% Risk-Free Rate, a 1.20 Beta, and a 10.00% Expected Market Return:
- Step 1 (Identify Inputs): $R_f = 4.00\%$, $\beta = 1.20$, $R_m = 10.00\%$.
- Step 2 (Calculate Equity Risk Premium ERP): $ERP = 10.00\% - 4.00\% = \mathbf{6.00\%}$.
- Step 3 (Calculate Beta Risk Adjustment): $\beta \times ERP = 1.20 \times 6.00\% = \mathbf{7.20\%}$.
- Step 4 (Add Risk Adjustment to Risk-Free Baseline): $R_e = 4.00\% + 7.20\% = \mathbf{11.20\% \text{ Expected Return (Cost of Equity)}}$.
- Step 5 (Evaluate Investment Hurdle): Investors require an **11.20% return** to hold this stock. In a WACC calculation, equity capital for this firm is priced at 11.20%!
Calculation Examples: Real-World Scenario Comparison
Compare CAPM Expected Returns across stock risk profiles ($R_f=4.0\%$, $R_m=10.0\%$, $ERP=6.0\%$):
| Stock Category & Profile | Stock Beta ($\beta$) | Equity Risk Premium | Risk Premium Added | Expected Return (Cost of Equity $R_e$) |
|---|---|---|---|---|
| Defensive Electric Utility | 0.50 Low Volatility | 6.00% | +3.00% | 7.00% Expected Return |
| S&P 500 Index Benchmark | 1.00 Market Average | 6.00% | +6.00% | 10.00% Expected Return |
| High-Growth Tech Enterprise | 1.50 High Volatility | 6.00% | +9.00% | 13.00% Expected Return |
| Speculative Biotech Small-Cap | 2.00 Very High Volatility | 6.00% | +12.00% | 16.00% Expected Return |
Benefits of Using the CAPM Calculator
Utilizing this calculator provides key corporate valuation advantages:
- Provides Standard Cost of Equity Input: Supplies the exact $R_e$ value needed for corporate WACC models.
- Adjusts Return Expectations for Volatility: Quantifies how much additional return is required for taking on higher stock Beta.
- Benchmark for Portfolio Performance (Alpha): If a portfolio generates returns above CAPM expected return, it achieves positive Alpha ($\alpha$).
- Grounded in Nobep-Prize Winning Financial Theory: Developed by William Sharpe, CAPM remains the foundation of modern portfolio theory (MPT).
Frequently Asked Questions (FAQ)
What is CAPM (Capital Asset Pricing Model)?
CAPM is a financial model that calculates the expected return of an asset based on its systematic risk (Beta) relative to the broader market.
What is Beta ($\beta$) in stock valuation?
Beta measures how much a stock's price moves relative to the overall market. Beta = 1.0 means the stock moves in tandem with the market; Beta = 1.5 means it is 50% more volatile than the market.
What is the Risk-Free Rate ($R_f$)?
The risk-free rate is the theoretical rate of return of an investment with zero risk of financial default, typically represented by the 10-Year US Treasury note yield.
What is Equity Risk Premium (ERP)?
ERP is the extra return investors demand for investing in risky stocks rather than risk-free government bonds (ERP = R_m - R_f, historically 5% to 7%).
What is the difference between systematic risk and unsystematic risk?
Systematic risk (market risk) affects all companies (recessions, interest rates) and cannot be diversified away. Unsystematic risk is company-specific and can be eliminated through portfolio diversification.
Can Beta be negative?
Yes! A negative Beta means the stock moves inversely to the market (e.g. Gold mining stocks or inverse ETFs with Beta = -1.0).
What is Alpha ($\alpha$) in relation to CAPM?
Alpha is the excess return an investment earns over its CAPM expected return. Positive Alpha indicates superior stock selection or fund management.
How is CAPM used in Corporate Finance?
Financial managers use CAPM to calculate the Cost of Equity ($R_e$), which is then combined with the Cost of Debt to calculate WACC.
What are the main criticisms of CAPM?
Critiques note that CAPM assumes efficient markets, single-period horizons, and relies heavily on historical Beta, which may not predict future volatility accurately.
What is the Security Market Line (SML)?
The Security Market Line is a graphical representation of the CAPM formula, displaying Beta on the x-axis and Expected Return on the y-axis.