Financial Management · Estimating the cost of capital

CAPM and Cost of Equity for ACCA FM

Updated 11 October 2026 · Fact-checked

The capital asset pricing model (CAPM) estimates the cost of equity as the risk-free rate plus beta times the equity risk premium: Ke = Rf + β(Rm − Rf). Beta measures systematic risk. You find Rf, Rm − Rf and β in the question, then substitute and calculate.

Understand CAPM and Cost of Equity

Shareholders put money into a company and want a return. That required return is the cost of equity. The company must earn at least this on new projects, or shareholder wealth falls.

The CAPM links required return to risk. It says investors are paid only for systematic risk, the risk that comes from the whole market (economic cycles, interest rates). Unsystematic risk is specific to one company. A well-diversified investor removes it, so the market does not reward it.

Beta (β) measures how sensitive a share's returns are to market returns. A beta of 1 means the share moves with the market. A beta above 1 means it moves more than the market, so it is riskier and needs a higher return. A beta below 1 means it is less volatile than the market.

The equity risk premium is Rm − Rf: the extra return the market gives over the risk-free rate. The risk-free rate is usually the yield on short-term government securities. Multiply the premium by beta, then add the risk-free rate.

The dividend growth model (DVM) uses a different route: it works from the current share price, the dividend and expected growth. CAPM uses risk and market data. CAPM allows for risk explicitly and does not need dividend growth, but it relies on beta, Rf and Rm, which are hard to estimate and based on past data. The DVM relies on a growth estimate, which is also uncertain, and assumes growth is constant.

Key rules to remember

CAPM cost of equity: Ke = Rf + β × (Rm − Rf); Rm − Rf is the equity risk premium. If the question gives Rm (market return) rather than the premium, subtract Rf first.
Equity risk premium: Equity risk premium = Rm − Rf; Do not add Rf a second time when the premium is given.
Dividend growth model (cost of equity): Ke = [D0 × (1 + g) ÷ P0] + g; P0 must be ex-dividend. D0 is the dividend just paid. Use for comparison with CAPM.
Geometric growth rate: g = (latest dividend ÷ earliest dividend)^(1 ÷ n) − 1; n is the number of years of growth, which is one fewer than the number of dividends listed.

How to solve CAPM and Cost of Equity questions

Use this method for any CAPM cost of equity question, whether it is a two-mark objective question or part of a written WACC calculation.

1Identify what the question gives: Rf, Rm or the equity risk premium, and beta.
2Check whether the figure is the market return (Rm) or the premium (Rm − Rf). They are not the same.
3Write the formula: Ke = Rf + β(Rm − Rf).
4Substitute the numbers and multiply beta by the premium first.
5Add Rf and state the answer as a percentage, usually to one or two decimal places.
6If a comparison is asked, calculate the DVM figure with the same care and compare the two results.
7Comment briefly where required: CAPM reflects systematic risk only, and its inputs are estimates.
8If the cost of equity feeds into WACC, carry the unrounded figure forward and show it clearly.

Quickest way: Premium first, then beta, then Rf

When to use it: Section A and Section B objective questions where you have about three minutes per question or less.

Circle whether you have Rm or the premium.
If you have Rm, subtract Rf to get the premium.
Multiply premium by beta.
Add Rf.
Check that the answer is sensible: beta above 1 must give Ke above Rm; beta below 1 must give Ke between Rf and Rm.

Common mistakes in CAPM and Cost of Equity

Using Rm as the equity risk premium.
Students see a market return figure and multiply beta by it directly.
Fix: Always subtract Rf from Rm before multiplying by beta, unless the question states the premium itself.
Forgetting to add the risk-free rate at the end.
Students stop after calculating β × premium.
Fix: Write the full formula first and tick off each part. Ke can never be below Rf when beta is positive.
Applying a tax adjustment to the cost of equity.
Students confuse it with the after-tax cost of debt.
Fix: Dividends are paid from after-tax profits, so there is no tax saving. Do not adjust Ke for tax.
Treating beta as total risk.
Beta is described as a measure of risk without saying which type.
Fix: State that beta measures systematic risk only. Unsystematic risk is diversified away and is not rewarded.
Using the cum-dividend price or D0 instead of D1 in the DVM comparison.
Rushing to compare models.
Fix: Use D0 × (1 + g) as the numerator and an ex-dividend price.
Saying one model is always better.
Students want a simple answer in the discussion part.
Fix: Give the strengths and weaknesses of each. CAPM allows for risk but depends on estimated inputs; DVM is simple but depends on a constant growth assumption.

Worked examples

Example 1

A company has a beta of 1.2. The risk-free rate is 4% and the expected return on the market is 9%. Calculate the cost of equity using the CAPM.

Show the solution

Equity risk premium = Rm − Rf = 9% − 4% = 5%.
β × premium = 1.2 × 5% = 6%.
Ke = Rf + 6% = 4% + 6% = 10%.

Answer: Cost of equity = 10%.

Example 2

A company's shares have an ex-dividend price of $4.00. It has just paid a dividend of $0.30 per share and dividends grow at 5% a year. Its beta is 0.9, the risk-free rate is 3% and the equity risk premium is 6%. Calculate the cost of equity using (a) the dividend growth model and (b) the CAPM, and comment.

Show the solution

(a) D1 = 0.30 × 1.05 = $0.315.
D1 ÷ P0 = 0.315 ÷ 4.00 = 7.875%.
Ke = 7.875% + 5% = 12.875%, about 12.9%.
(b) β × premium = 0.9 × 6% = 5.4%.
Ke = 3% + 5.4% = 8.4%.
Comment: the two results differ by about 4.5 percentage points. The DVM relies on a constant growth rate of 5%, which may be too high. The CAPM relies on estimates of beta and the premium and considers only systematic risk. Check the inputs of both before choosing.

Answer: DVM Ke = about 12.9%; CAPM Ke = 8.4%. The gap suggests one or more inputs are unreliable, so further investigation is needed.

Exam tips

Read carefully whether the question gives Rm or the equity risk premium. Examiners often test this.
In objective questions, a quick sense check helps: beta above 1 means Ke is above the market return.
In written parts, comparing CAPM with the DVM needs both strengths and weaknesses, not just a statement of formulas.
Show the CAPM formula and each step in a Section C answer so you earn method marks even if an input is misread.
When Ke feeds into WACC, keep the unrounded value until the final step.

Practice questions from Estimating the cost of capital

CAPM and Cost of Equity in other exams

The same ground in other exams, if you are preparing for more than one or want another angle on it.

CAPM and Cost of Equity: frequently asked questions

How do I calculate the cost of equity using CAPM in ACCA FM?

Use Ke = Rf + β(Rm − Rf). Find the equity risk premium (Rm − Rf), multiply it by beta, then add the risk-free rate. The formula is given in the FM exam formulae sheet, but you must know how to apply it.

What is the difference between the dividend growth model and CAPM?

The DVM uses the share price, the latest dividend and expected dividend growth. CAPM uses the risk-free rate, beta and the equity risk premium. CAPM explicitly reflects systematic risk, while the DVM only reflects it indirectly through the share price.

What does beta measure?

Beta measures systematic risk: how much a share's return moves relative to the market. A beta of 1 moves with the market, above 1 is more volatile, and below 1 is less volatile.

Why is unsystematic risk ignored in CAPM?

Investors can remove it by holding a diversified portfolio. Because it can be eliminated at low cost, the market does not pay a return for bearing it.