Financial Glossary
Capital Asset Pricing Model (CAPM)
The Capital Asset Pricing Model (CAPM) is a framework for estimating the expected return of an asset given its systematic risk relative to the overall market. The formula is: Expected Return = Risk-Free Rate + Beta x (Market Return - Risk-Free Rate), where the term in parentheses is the equity risk premium and Beta measures the asset's sensitivity to market movements. A Beta of 1 means the asset moves in line with the market; above 1 indicates higher volatility. CAPM is widely used in corporate finance to derive the cost of equity capital for valuation and investment decision-making.
Problem & Application
A private equity firm evaluating an acquisition of a campground portfolio needs to establish a discount rate for its DCF model. The risk-free rate (approximated by long-term government bond yields) is one input; the other is a Beta estimate for publicly traded outdoor hospitality or leisure companies adjusted for the target's leverage. Suppose the peer group has an unlevered Beta of 0.8 and the target will be 60% debt-financed. The firm relevered the Beta to approximately 1.4, yielding a cost of equity of around 12% given an assumed equity risk premium. This cost of equity feeds into the WACC, which then discounts projected campground cash flows to arrive at an enterprise value. Small changes in the Beta assumption materially shift the valuation, highlighting why selecting comparable companies carefully matters.
In Short
CAPM remains a foundational tool in finance, guiding investors in making informed decisions by balancing risk and reward.