Capital Asset Pricing Model – Cost of Debt Capital and cost of Preference Share Capital are easy to calculate as they depend on actual after tax cash outflows on account of interest payment but calculation of cost of Equity Capital is little tough as it depends on market expected rate of return. There are many theories to calculate cost of Equity Capital. Out of all those theories Capital Asset Pricing Model (CAPM) is the most widely used method of calculating the Cost of Equity Capital. Under CAPM cost of Equity Capital is expressed as
Risk Free Rate + Specific Risk Premium
or Risk Free Rate + Beta x Equity Risk Premium
or Risk Free Rate + Beta x (Market Rate – Risk Free Rate)
The risk free rate represents the most secure return that can be achieved. There is no consensus among the practitioners regarding risk free rate.
Specific Risk Premium is a multiple of Beta and Equity Risk Premium. Equity Risk Premium is almost same for all the listed companies in the stock market. Unless the volatility of share prices and share market indices of two companies are same, their Beta will be different.