CAPM
The Capital Asset Pricing Model (CAPM) is used to calculate the discount rate per the following formula:
Example:
Suppose an investment is twice as risky as investing in the stock market. The beta is 2, in this example. Suppost the stock market has yielded 11% return in the last fifty years, so the market rate of return is 11%. Suppose the US Treasury note which matures in 10 years currently yields 6%, so the risk-free rate of return is 6%.
Using CAPM, the discount rate r is calculated as follows:
r = 6% + 2 (11% - 6%) = 6% + 10% = 16%
So, 16% should be used as r in the NPV (net present value) calculations. For NPV, please click on the NPV link to the left.
