How is the cost of equity determined according to the Capital Asset Pricing Model (CAPM)?

The Capital Asset Pricing Model (CAPM) is a widely used financial model that calculates the expected return on an investment, which in this case is the cost of equity. The cost of equity is essentially the return required by investors to compensate them for the risk of investing in a company's equity.

According to CAPM, the cost of equity is determined using a formula that incorporates three key components: the risk-free rate, beta, and the equity risk premium.

• The risk-free rate represents the return on an investment with no risk of financial loss, typically based on government treasury bonds.

• Beta measures the sensitivity of the investment's returns to the overall market returns, indicating how much risk the stock is exposed to compared to the market as a whole.

• The equity risk premium is the additional return investors expect to earn over the risk-free rate as compensation for taking on the additional risk of investing in stocks.

By combining these elements, CAPM allows investors to estimate what return they should expect based on the inherent risk of the investment. This model emphasizes the relationship between expected return and risk, making it a fundamental tool in finance for determining the cost of equity.

Other options don't align with the CAPM methodology. The approach of using total assets minus