Capital Asset Pricing Model

Many companies pay no dividend to their shareholders. When the company pays no dividend, the Dividend Growth Model cannot be used to calculate the cost of its equity capital. Therefore, the Capital Asset Pricing Model (CAPM) is frequently used to estimate the cost of equity—either retained earnings or new equity.

In cases of new equity offerings with substantial flotation costs or underpricing (such as in IPOs or initial public offerings), use of the CAPM is not recommended.

The CAPM formula is:

R = R_F + β(R_M – R_F)

Where:

R ⇒ Investors’ required rate of return (cost of retained earnings)

R_F ⇒ Risk-free rate of return

β ⇒ Beta coefficient

R_M  ⇒ Expected rate of return for the market portfolio