In this episode, we delve into one of the most widely used tools in finance: the Capital Asset Pricing Model (CAPM). CAPM helps analysts and investors estimate the cost of capital required for investment projects by determining the expected rate of return based on the project's risk. We begin by exploring how CAPM connects risk and return using the key variables of the risk-free rate, market risk premium, and beta. Beta, in particular, reflects an asset’s systematic risk relative to the market, allowing us to understand how much an asset's return is expected to fluctuate with market movements.

Listeners will gain insights into calculating beta, including practical methods for estimating beta using historical data and stock market indices. We discuss how the Security Market Line (SML) visually represents CAPM’s approach to risk-adjusted returns and what a project’s position on this line indicates about its risk and expected return.

We also cover how companies use CAPM to make investment decisions by applying a project-specific discount rate that reflects the systematic risk of similar assets. For those navigating complex projects or industries, we explore methods to adjust beta by leveraging industry betas or similar companies' equity betas.

The episode addresses CAPM’s limitations, including the challenges of accurately estimating future risk and returns and the model’s reliance on the assumption of market efficiency. We discuss alpha as a measure of an asset’s performance relative to CAPM predictions and highlight when it might signal investment opportunities. Finally, we touch on alternatives to CAPM, such as multifactor models, for a more nuanced view of asset pricing.

Tune in to understand how CAPM remains a foundational tool for assessing investment risk, expected return, and cost of capital, and discover practical insights for applying it in project evaluation and corporate finance.