



The risk-free rate is estimated based on the rate of return of short-term Treasury bills, because these securities have stable values with guaranteed returns backed by the U.S. government. The market risk premium is equal to the market return minus the risk-free rate. This reflects the percentage of investment return that can be attributed to the stock market's volatility.


The cost of equity capital, as determined using the CAPM method, is equal to the risk-free rate plus the market risk premium multiplied by the beta value of the stock in question. A stock's beta value is an important metric that reflects the volatility of a given stock relative to the volatility of the larger market. A beta value of 1 indicates that the stock in question is equally as volatile as the larger market. If the S&P 500 jumps 15%, the stock shows similar gains. Beta values between 0 and 1 indicate the stock is less volatile than the market, while values above 1 indicate greater volatility. A beta value of 0 indicates that the stock is completely stable.

Assume the stock in question has a beta value of 1.2, the Nasdaq generates average returns of 10% and the guaranteed rate of return on short-term Treasury bonds is 5.5%. Using the CAPM model, the rate of return that can reasonably be expected by investors is:

﻿Return=5.5%+1.2×(10%5.5%)=10.9%\begin{aligned} &\text{Return} = 5.5\% + 1.2 \times (10\% - 5.5\%) = 10.9\% \\ \end{aligned}Return=5.5%+1.2×(10%5.5%)=10.9%﻿
