{"id":21837,"date":"2021-09-30T12:57:26","date_gmt":"2021-09-30T12:57:26","guid":{"rendered":"https:\/\/analystprep.com\/study-notes\/?p=21837"},"modified":"2024-04-06T03:25:52","modified_gmt":"2024-04-06T03:25:52","slug":"required-rate-of-return-models","status":"publish","type":"post","link":"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/required-rate-of-return-models\/","title":{"rendered":"Required Rate of Return Models"},"content":{"rendered":"<p><iframe loading=\"lazy\" src=\"\/\/www.youtube.com\/embed\/LLxHIyf6cUs\" width=\"611\" height=\"343\" allowfullscreen=\"allowfullscreen\"><\/iframe><\/p>\n<h3>The CAPM<\/h3>\n<p>$$\\begin{align*}\\text{Required return on equity}&amp;= \\text{Risk-free rate} \\\\&amp;+ (\\text{Beta} \\times \\text{Market risk premium})\\end{align*}$$<\/p>\n<p>The CAPM is generally inappropriate for private entities.<\/p>\n<h3>Expanded CAPM<\/h3>\n<p>$$\\begin{align*}\\text{Required return on equity} &amp;= \\text{Risk-free rate} + (\\text{Beta} \\times \\text{Market risk premium}) \\\\&amp;+ \\text{Small stock premium} \\\\&amp;+ \\text{Company-specific risk premium}\\end{align*}$$<\/p>\n<h3>Build-Up Approach<\/h3>\n<p>$$\\begin{align*}\\text{Required return on equity}&amp; = \\text{Risk-free rate} + \\text{Equity risk premium} \\\\&amp;+ \\text{Small stock premium} \\\\&amp;+ \\text{Company-specific risk premium} \\\\&amp;+ \\text{Industry risk premium}\\end{align*}$$<\/p>\n<p>The build-up approach is often used when guideline public companies are unavailable.<\/p>\n<h4>Example: Comparing Required Return Models<\/h4>\n<p>Consider the following information:<\/p>\n<p>$$\\small{\\begin{array}{l|r}\\text{Risk-free rate} &amp; 1.25\\% \\\\ \\hline \\text{Equity risk premium} &amp; 7.50\\% \\\\\u00a0 \\hline\\text{Beta} &amp; 1.875 \\\\ \\hline \\text{Small stock premium} &amp; 5.00\\% \\\\ \\hline\\text{Company-specific risk premium} &amp; 1.88\\% \\\\ \\hline\\text{Industry risk premium} &amp; 1.50\\% \\end{array}}$$<\/p>\n<h4>CAPM<\/h4>\n<p>$$\\begin{align*} (\\text{R}_{\\text{E}})&amp;=1.25\\%+1.875\u00d77.50\\%\\\\&amp;= 15.31\\%\\end{align*}$$<\/p>\n<h4>Expanded CAPM<\/h4>\n<p>$$\\begin{align*}\\text{R}_{\\text{E}}&amp;=1.25\\%+(1.875\u00d77.50\\%)+5\\%+1.88\\%\\\\&amp;= 22.19\\%\\end{align*}$$<\/p>\n<h4>Build up Approach<\/h4>\n<p>$$\\begin{align*}\\text{R}_{\\text{E}}&amp;=1.25\\%+7.50\\%+5\\%+1.88\\%+1.50\\%\\\\&amp;= 17.13\\%\\end{align*}$$<\/p>\n<p>Reading 27: Private Company Valuation<\/p>\n<p><em>LOS 27 (e) Compare models used to estimate the required rate of return to private company equity (for example, the CAPM, the expanded CAPM, and the build-up approach).<\/em><\/p>\n","protected":false},"excerpt":{"rendered":"<p>The CAPM $$\\begin{align*}\\text{Required return on equity}&amp;= \\text{Risk-free rate} \\\\&amp;+ (\\text{Beta} \\times \\text{Market risk premium})\\end{align*}$$ The CAPM is generally inappropriate for private entities. Expanded CAPM $$\\begin{align*}\\text{Required return on equity} &amp;= \\text{Risk-free rate} + (\\text{Beta} \\times \\text{Market risk premium}) \\\\&amp;+ \\text{Small stock&#8230;<\/p>\n","protected":false},"author":5,"featured_media":0,"comment_status":"closed","ping_status":"closed","sticky":false,"template":"","format":"standard","meta":{"_acf_changed":false,"footnotes":""},"categories":[102,401],"tags":[216,402],"class_list":["post-21837","post","type-post","status-publish","format-standard","hentry","category-cfa-level-2","category-equity-valuation","tag-cfa-level-2","tag-equity-valuation","blog-post","no-post-thumbnail","animate"],"acf":[],"yoast_head":"<!-- This site is optimized with the Yoast SEO plugin v26.9 - https:\/\/yoast.com\/product\/yoast-seo-wordpress\/ -->\n<title>Required Rate of Return Models - CFA, FRM, and Actuarial Exams Study Notes<\/title>\n<meta name=\"description\" content=\"Understand the components and differences in the CAPM, Expanded CAPM, and Build-Up Approach models, essential for private company valuation.\" \/>\n<meta name=\"robots\" content=\"index, follow, max-snippet:-1, max-image-preview:large, max-video-preview:-1\" \/>\n<link rel=\"canonical\" href=\"https:\/\/analystprep.com\/study-notes\/cfa-level-2\/required-rate-of-return-models\/\" \/>\n<meta property=\"og:locale\" content=\"en_US\" \/>\n<meta property=\"og:type\" content=\"article\" \/>\n<meta property=\"og:title\" content=\"Required Rate of Return Models - 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