Capital Asset Pricing Model estimates the cost of equity on the basis of risk free rate and expected return. It calculates the expected return on an investment which helps in the comparison of expected return with the required rate of return so as determine whether the asset is underpriced, overpriced or properly priced. The main logic which governs the capital asset pricing model is that investors should get a benefit for both waiting and worrying. The larger the worry, higher will be the expected return. If investment is made in a risk-free Treasury bill, then only the risk free rate of interest will be received. When you invest in risky stocks, you can expect an extra return over the risk free rate or risk premium for worrying, which is called as reward for worrying.
The strength of Capital Asset Pricing Model is that it is easy to understand and can be easily understood by a layman. It is consistent with real world of investment. The weakness of Capital Asset Pricing Model is that it is based on assumptions and it is not subject to either taxes or transaction costs. The assumptions made are narrow and inadequate for explaining the real life situations
Security Market Line Equation:
Ke = Rf + Beta * (Rm – Rf)
Ke = Cost of Equity
Rf = Risk free rate