AN UNIFIED APPROACH TO THE COST OF CAPITAL USING CAPM AND MODIGLIANI

In this paper, I try to make a synthesis of Modigliani an Miller Theory (MM) and Capital Asset Pricing Model (CAPM). The cost of capital is seen to be a rate of return whose definition requires a project to improve the wealth position of current shareholders of the firm. The original Modigliani-Miller work has been extending by using the CAPM. Key words: model, cost of capital, assets, stock, risk Generally, CAPM provides a natural theory to determinate the market price for risk and yhe appropriate measure of risk. This model was developed almost simultaneously by Sharpe (1963,1964) and Treynor (1961), and Mossin (1966), Lintner (1965,1969) and Black (1972) developed it further. This model show that the equilibrium rates of return on all risky assets are function of their covariance with the market portofolio. But CAPM has a lot of implications for some corporate policy decision. So, the cost of equity capital for a firm is given directly by CAPM. After all, the company's beta is measured by calculating the covariance between the return on its common stock and the market index. Consequently, the beta measures the systematicrisk of the common stock, and if we know the systematic risk, we can use the CAPM to determine the require rate of return on equity. Equation (1) is known as the capital asset pricing model, CAPM: S(Ri) =RF +βi[S(RM)-RF] (1) where: S(Ri) = the expected rate of return on asset i; RF = the risk-free rate (constant); S(RM) = the expected rate of return on the market portofolio. It is shown graphically in fig.1, where it is also called the security market line. All securities fall exactly on the security market line. The required rate of return on any asset, S(Ri) in eq (1), is equal to the risk-free rate of return plus a risk premium. The risk premium is the price of risk multiplied by the quantity of risk. In the terminology of the CAPM, the price of risk is the slope of the line, the difference between the expected rate of return on the market portofolio and the risk-free rate of return. The quantity of risk is ofen called beta, βi.