Determining the cost of equity using the CAPM

While the cost of debt corresponds to the effective interest rates of creditors, determining the cost of equity is significantly more difficult. Calculate the cost of equity for your company with the help of our article!

CAPM Formula

The capital costs of a company consist of both debt and equity costs. While the former can be easily identified based on interest expense, the equity costs, on the other hand, must be calculated. The most commonly used method for this is the Capital Asset Pricing Model (CAPM). According to the CAPM, the cost of equity [rEK] equals the risk-free interest rate [rf] (e.g., the yield of federal bonds) plus the multiplication of the market return (e.g., the SMI return [E(rm)] minus the risk-free interest rate) with the company-specific risk [β]:

CAPM – Step by Step

1. Determination of the risk-free interest rate:

‍As a rule, government bonds with top credit ratings are considered risk-free investments. Currently, Swiss federal obligations with a maturity of 10 years have a yield of -0.24%.

‍2. Determination of the Market Risk Premium:

‍The market risk premium represents the difference between the market return and the risk-free interest rate. Broad stock indices, such as the SMI, are suitable for determining the market return. The historical market risk premium of the SMI, i.e., the outperformance of the stock index compared to Swiss federal obligations, is approximately 8%.

‍3. Determination of Beta:

‍The company-specific risk is captured with a multiplier that usually ranges between 0.7 and 1.3. The more cyclical an industry is, the higher the beta tends to be. For private companies, the beta is calculated based on comparable, publicly listed companies. On the website of Aswath Damodaran, a professor from NYU Stern School of Business, betas can be found by various industries and geographic regions.

‍4. Calculation of the Cost of Equity:

‍According to the CAPM, for example, a Swiss company active in e-commerce has the following cost of equity: