Capital Asset Pricing Model (CAPM)

CAPM answers one question: given how risky this stock is, what return should investors expect? The logic is that investors only get paid for risk they can't diversify away — systematic, market-wide risk. Company-specific risk can be diversified, so the market doesn't compensate you for it. CAPM captures systematic risk through beta. A beta of 1.0 means the stock moves in line with the market; 1.5 means it's 50% more volatile (so investors demand more return); 0.7 means it's less volatile (less return needed). The model layers this on top of the risk-free rate to produce the cost of equity.

Risk-free rate: typically the yield on a 10-year (sometimes 20-year) US Treasury, matching the long-term horizon of a DCF. Beta: measured by regressing the stock's returns against the market, but in practice you usually pull comparable companies' betas, un-lever them, then re-lever at your target's capital structure — see levered vs unlevered beta. Equity risk premium: the historical excess return of stocks over the risk-free rate, commonly assumed around 5-7%. Because two of the three inputs are estimates, small assumption changes meaningfully move the cost of equity — which is why interviewers probe each input.

CAPM is the market standard because it's simple, defensible, and grounded in the idea that only non-diversifiable risk should be priced. But it leans on shaky assumptions: betas are unstable and backward-looking, the equity risk premium is debated, and the model assumes a single-factor world where beta explains all systematic risk. Critics point to size and value factors (Fama-French) that CAPM ignores. For private companies with no observable beta, you have to borrow betas from public comps. Despite the flaws, in an IB interview CAPM is THE expected answer for cost of equity — know it cold.