CAPM and WACC
CAPM (Capital Asset Pricing Model) and WACC (Weighted Average Cost of Capital) are two important concepts in finance that are used to estimate the cost of equity and the cost of capital for a company. While they serve different purposes, they are interconnected and used in capital budgeting and valuation analyses.
CAPM: CAPM is a model that helps determine the expected return on an investment based on its systematic risk. It provides a way to estimate the cost of equity, which is the return required by investors to hold the company’s stock. The CAPM formula is as follows:
r = Rf + β * (Rm – Rf)
Where:
- r is the expected return on the stock
- Rf is the risk-free rate of return
- β (beta) is the measure of the stock’s systematic risk
- Rm is the expected return of the market
The CAPM equation states that the expected return on a stock is equal to the risk-free rate plus a risk premium determined by the stock’s beta and the market risk premium. The beta measures the sensitivity of the stock’s returns to market movements. By using the CAPM, companies can estimate the appropriate return on equity and determine the cost of equity for their projects or investments.
WACC: WACC is a calculation that represents the average cost of capital for a company, taking into account the weightings of different sources of capital (debt and equity) in the company’s capital structure. It is used to discount future cash flows in capital budgeting decisions. The WACC formula is as follows:
WACC = (E/V) * Ke + (D/V) * Kd * (1 – Tax Rate)
Where:
- E is the market value of equity
- V is the total market value of the firm’s capital structure (E + D)
- Ke is the cost of equity
- D is the market value of debt
- Kd is the cost of debt
- Tax Rate is the corporate tax rate
The WACC equation represents a weighted average of the cost of equity and the after-tax cost of debt. The weights are based on the proportions of equity and debt in the company’s capital structure. By using the WACC, companies can determine the appropriate discount rate to evaluate the net present value of their projects or investments.
Relationship between CAPM and WACC: CAPM is used to determine the cost of equity, which is one component of the WACC calculation. The cost of equity obtained from the CAPM is combined with the cost of debt (adjusted for taxes) to calculate the WACC. The WACC represents the overall cost of capital for the company, considering the proportions of equity and debt in the capital structure.
In summary, CAPM helps estimate the cost of equity, while WACC provides the overall cost of capital for the company. Both are important in financial decision-making, including capital budgeting, valuation, and determining the required return on investments.