CAPM and Cost of Equity Calculation

CAPM determines the expected return of an investment by incorporating three key components: the risk-free rate, which represents the return on a risk-free asset; beta, which measures the investment's volatility relative to the market; and the market risk premium, which reflects the additional return expected from investing in the market over the risk-free rate.

In the Capital Asset Pricing Model (CAPM), the risk-free rate represents the return expected from an investment with no risk of financial loss. It is often associated with government securities, as they are considered safe and stable, providing a benchmark for evaluating the performance of riskier investments.

Beta quantifies a stock's systematic risk, which reflects its sensitivity to market movements. A beta greater than 1 indicates higher volatility compared to the market, while a beta less than 1 suggests lower volatility. This measure helps investors assess the risk associated with a stock in relation to broader market trends.

A beta of 1.5 indicates that the stock's price movements are 50% more volatile than the overall market. This means that when the market moves, the stock is expected to experience larger fluctuations in price, making it a riskier investment compared to stocks with a beta of 1 or less.

The market risk premium in the Capital Asset Pricing Model (CAPM) represents the additional return investors expect for taking on the risk of investing in the market compared to a risk-free asset. It is calculated by subtracting the risk-free rate from the expected market return, reflecting the compensation for that risk.

To calculate the expected return using CAPM, apply the formula: Expected Return = Risk-Free Rate + (Beta × Market Risk Premium). Substituting the values: 3% + (1.2 × 6%) = 3% + 7.2% = 10.2%. Thus, the expected return for the stock is 10.2%.

A defensive stock is characterized by its stability and lower volatility compared to the broader market. A beta less than 1 indicates that the stock tends to move less than the market in response to economic changes, making it a safer investment during downturns. This quality attracts risk-averse investors seeking to preserve capital.

CAPM (Capital Asset Pricing Model) assumes that markets are perfectly efficient and frictionless, meaning all available information is reflected in asset prices. Additionally, it posits that all investors share the same investment horizons and expectations, leading to uniform decision-making. Thus, both statements a and c accurately reflect CAPM assumptions.

The cost of equity calculated using the Capital Asset Pricing Model (CAPM) reflects the return that investors require for taking on the risk of owning a company's stock. It serves as a benchmark, indicating the minimum return shareholders expect to receive to compensate for the risk associated with their investment.

When the expected market return decreases while the risk-free rate stays the same, the market risk premium, which is the difference between the expected market return and the risk-free rate, also decreases. This reflects a lower reward for taking on additional risk, indicating less incentive for investors to invest in the market over safer assets.

Unsystematic risk, also known as specific or idiosyncratic risk, pertains to individual assets or companies and can be mitigated through diversification. By holding a varied portfolio, investors can offset losses from any single investment, thus reducing overall risk without affecting expected returns, as systematic risk remains inherent to the market as a whole.

A beta of 0.8 suggests that the company's stock is less volatile than the market, which has a beta of 1. Stocks with a beta below 1 are generally considered to have lower risk, as they tend to move less dramatically in response to market changes, indicating more stable performance.