Question

what exactly is Capital Asset Pricing Model (CAPM)and how could you use it to value a firm? Can you illustrate using a very simple example that you make up yourself?

Answer 1

Capital Asset pricing model is a model which will be used to find out the expected rate of return for investment into various Assets and it will be used to find out the rate of return after determination of the risk free rate of return in the market and adjusting it with the beta along with market premium.

Expected rate of return= risk free return+(beta X market risk premium )

Beta is representative of the systematic risk associated with the company and when there will be a higher amount of risk associated with investment, there will be a higher expectation of expected rate of return for the company.

Very simple example would be that right now, the risk-free rate is around 3% whereas the beta of Tesla is 1.8 and the market risk premium is 4% and when we are finding out the expected rate of return of Tesla= (3+(1.8*4)= 10.20%, hence the expected rate of return of Tesla would be 10.20 percent.