Capital Assets Price Model — Microsoft Excel
In this article, we will discussing about the capital asset price model in finance using excel. It explains the connection between the expected return and risk of investing in a security and we can also figure out some important reasons that can cause these risks that sometimes leads to fall of a company.
Capital Asset Price Model
A model that explains the connection between the expected return and risk of investing in a security is called the Capital Asset Pricing Model. It demonstrates that a security’s expected return is equal to its risk free return plus a
risk premium calculated using the security’s beta.
CAPM Formula:
Expected Rate of Return = Risk Free Premium + Beta * (Market Risk Premium)
RI = RF + β*(RM – RF)
Where,
RI: Rate of expected return/cost of equity.
RF: Risk free return.
β: Beta is the
systemic risk.
RM: Market risk.
If β > 1, market risk is higher.
If β < 1, market risk is lower.
We can find the β of every listed company on any financial website.
As we can see in the above figure, the Beta for TCS is 0.69.
Beta is the systemic risk of inflation, recession, natural disasters and such. An example of risk-free returns is interest on saving accounts or FDs. The time value
of money is taken into consideration by the risk free rate in the CAPM formula. The
other elements of the CAPM formula take the investor’s increased risk into account.
Let’s take an example to understand this better.
An investor decides to invest in a stock called XYZ @ ₹1,000/- per share, it pays
an annual dividend of 5%. The stock beta is 1.2, which means it is riskier than the market portfolio. Let’s assume that the risk free rate is 6% and the investor expected
the market to rise in value by 10% per year.
CAPM Formula:
Expected Rate of Return = Risk Free Premium + Beta * (Market Risk Premium)
RI = RF + β*(RM – RF)
RI = 6% + 1.2*(10%-6%) = 10.80%
Cost of Equity = 10.80%
Conclusion
Finally, we will take a descriptive drive of learning capital asset price model in finance and we also discussing it’s important and necessary formulas and principles that help us to seek better performance and alarm the risky situation in returns and investments.
