How could we adjust the CAPM formula to change our Cost of Equity?
Answer
You could add in an Industry Premium or Size Premium as ways to “right-size” the CoE compared to a company’s peers. For the Industry Premium, you would increase the CoE if the industry the company operates in is riskier than the broader market. For the Size Premium, you would add in extra risk if the company is smaller than the weighted average of the entire equity market.
Why this matters to bankers
The CAPM calculates Cost of Equity, which is used in the WACC calculation, which is used to discount Free Cash Flows and create a DCF! It’s the root of the accuracy of the whole thing.