In the CAPM model, the beta can be used to calculate the return required by the market for a security (cost of equity). This cost of equity can also be considered as a minimum return for possible investments of the company. What I don't understand is the following: The cost of capital calculated using the CAPM refers to the equity valued in the market, but not the nominal equity. So, if the cost of equity is 10% according to the capm, and the market valued equity is, say, 300, but the balance sheet (subscribed) equity is only 100 (price book ratio of 3), then the return on balance sheet equity would have to be 30% in order to serve the expected return on equity if the profit is fully distributed (or retained). Why, then, does one use the cost of capital of 10% calculated with the help of the capm for investment decisions (the return on which is an on-balance-sheet and not a market-valued variable)?


1 Answer 1


The CAPM model does not consider the balance sheet of the company. It does considered what business the company is in. The CAPM model assumes that the stock market is efficient. Not everybody agrees with that last assumption.

The CAPM model works under the assumption that a company with a low beta is safer to invest in then a company with a high beta. As such, investor will be happy with investments that have a low beta even if that means those companies offer lower rates of return.

I hope that helps. Feel free to ask a follow up question.


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