In CAPM, what is the formula to estimate the cost of equity?

• A. Re = Rf + beta*(Rm)
• B. Re = Rf + beta*(Rm - Rf)
• C. Re = Rf + beta + (Rm - Rf)
• D. Re = Rf * beta * (Rm - Rf)

Answer: (B)

In CAPM, the cost of equity reflects the time value of money plus compensation for systematic risk. It is calculated as the risk-free rate plus the asset’s beta times the market risk premium, where the market risk premium is the difference between the expected market return and the risk-free rate. So Re = Rf + beta*(Rm - Rf). This form correctly captures that only the excess market return above the risk-free rate is paid for taking on market risk, scaled by how sensitive the asset is to market movements. Using the total market return without subtracting the risk-free rate would double-count the baseline return, adding or multiplying terms in the other ways would misstate the premium and distort the result.