What does the Capital Asset Pricing Model (CAPM) help calculate?

The Capital Asset Pricing Model (CAPM) is primarily used to calculate the expected return on an investment, specifically focusing on the cost of equity. It establishes a relationship between the expected return of an asset and its systematic risk relative to the overall market. By using the formula:

Expected Return = Risk-Free Rate + Beta × (Market Return - Risk-Free Rate),

the CAPM enables analysts to determine the required return that equity investors expect for taking on the additional risk associated with investing in a particular stock, compared to risk-free investments.

In the context of discounted cash flow (DCF) analysis, the cost of equity is crucial, as it serves as the discount rate for equity cash flows. This means that when you value a company using DCF, the cost of equity derived from the CAPM directly impacts the present value of future cash flows attributable to equity holders.

Other options, while related to financial modeling and valuation, do not directly align with the specific purpose of CAPM. For instance, determining the cost of debt involves different methodologies, such as analyzing credit spreads or bond yields, and is not the focus of CAPM. The market risk premium, although a component of the CAPM formula, is not what is being calculated by the model