What does the CAPM equation include in its calculation of the cost of equity?

The CAPM (Capital Asset Pricing Model) equation is a widely used finance theory that establishes a linear relationship between the expected return of an asset and its risk, expressed in terms of its Beta. The correct components of the CAPM equation are the Risk-Free Rate, Beta, and the Equity Risk Premium.

The Risk-Free Rate represents the return on an investment with no risk of financial loss, typically based on government bonds. Beta measures the sensitivity of the asset’s returns to the returns of the market as a whole, indicating the risk associated with the asset compared to the market. The Equity Risk Premium is the additional return expected by investors for taking on the higher risk of investing in the stock market compared to risk-free assets.

Putting these components together, the CAPM formula calculates the expected return of an equity investment as follows: the expected return equals the Risk-Free Rate plus Beta multiplied by the Equity Risk Premium. This relationship helps investors make informed decisions regarding the pricing of equity securities.

The mention of just Beta and volatility, or only the Risk-Free Rate and market capitalization, or focusing solely on the Equity Risk Premium and market risk does not account for all the necessary components that define the cost of equity in the CAPM approach. Thus, the inclusion of all