The Problems of Calculation of Cost of Capital of Latvian Commercial Banks and Possible Solutions

Abstract

Cost of capital determination (discount rate) is a key component in assessment of investments efficiency and business valuation. However now, the attention is rarely paid to justification of the chosen rate. In this article the author examines the application of Capital Asset Pricing Model (CAPM) for equity capital assessment of commercial banks in Latvia. The basic idea of САРМ is that there is only one source of risk, which influences the profitableness of long-term investments - market risk, i.e. the tendency of shares to change its positions relatively to market share level in whole. This market risk is measured in САРМ by using beta coefficient. However use of САРМ assumes the developed stock market, therefore a determination of beta meets certain problems. The author of this publication suggests several versions of application of САРМ, considering specificity of the Latvian stock market. Cost of capital determination (discount rate) is a key component in assessment of investments efficiency and business valuation. However now, the attention is rarely paid to justification of the chosen rate. In this article the author examines the application of Capital Asset Pricing Model (CAPM) for equity capital assessment of commercial banks in Latvia. The basic idea of САРМ is that there is only one source of risk, which influences the profitableness of long-term investments - market risk, i.e. the tendency of shares to change its positions relatively to market share level in whole. This market risk is measured in САРМ by using beta coefficient. However use of САРМ assumes the developed stock market, therefore a determination of beta meets certain problems. The author of this publication suggests several versions of application of САРМ, considering specificity of the Latvian stock market