Question
The main components of the Capital Asset Pricing Model (CAPM) in capital budgeting are the risk-free rate, the beta of the investment, and the expected market return. The risk-free rate is the return on a risk-free investment, such as a government bond. The beta of the investment measures the investment's volatility compared to the market as a whole. The expected market return is the average return of the market. The CAPM formula uses these components to calculate the expected return on an investment given its risk relative to the market.
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The Capital Asset Pricing Model (CAPM) tab estimates the expected return on a stock based on its risk relative to the market. Using the CAPM formula, you can estimate the expected return, or profitability, of each stock and compare their respective levels of risk against your own risk tolerance. Say you are considering investing in two stocks, Tesla or Microsoft, but want to understand their potential returns based on their risk relative to the rest of the market. This might lead you to invest in Microsoft because of the volatility of Tesla, for example.
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