As an investor, student, or financial analyst, you may have come across the terms CAPM and WACC.
If you think they are similar, you are mistaken, as they are quite different. However, despite having distinct applications in the world of finance, they can be used together.
CAPM is a tool investors use to determine the expected return on an investment, while WACC is a measure of a company’s cost of capital (debt and equity). CAPM is based on the risk-free rate of return and a risk premium, while WACC focuses on the proportion of each source of capital and its cost. You can use the CAPM to calculate the cost of equity used in the WACC.
Wanna know more? Learn how to properly use CAPM and WACC:
What is the CAPM
The Capital Asset Pricing Model (CAPM) is a tool you can use to determine the expected return on a given investment. This investment can be a stock, bond, some other security, or a project.
The main idea behind CAPM is that the expected return on a security is equal to the risk-free rate of return plus a risk premium. The higher the risk, the higher the potential return.
To compute the CAPM, you need to first determine the risk-free rate of return. This is typically the coupon on a government bond from an established country like the United States, or Germany. Why? Because these are considered the safest investments you can make (AAA rating).
Next, you need to determine the expected return on the market as a whole. To do this, you can look at the historical returns of a market index, such as the S&P 500.
Lastly, you need the Beta of the security whose expected return you’re trying to compute. This is a measure of the stock’s volatility relative to the market.
Once you have these two numbers, you can use the following formula to calculate the expected return of a stock under the CAPM:
Expected Return = Risk-Free Rate + Beta x (Market Return – Risk-Free Rate)
Let’s say you want to invest in a high-risk tech start-up. Using the CAPM, you can determine the expected return on this investment by taking into account the risk-free rate of return and the beta of the start-up.
For example, if the risk-free is 3%, the expected return for the S&P 500 is 8%, and the beta of the company is 2, then its expected return is 13%:
3% + 2 x (8% – 3%) = 13%
What is the WACC
WACC, or the Weighted Average Cost of Capital, measures a company’s cost of capital. It is calculated by taking into account the proportion of each source of capital used to finance the business (debt and equity) and its cost.
How to Calculate the WACC
To calculate WACC, you need to first determine the proportion of debt and equity in the capital structure of the company.
In other words, how much debt does the company use to finance its assets? How much equity does the company use to finance its assets? You can find this information in the company’s financial statements.
Next, what is the cost for each source of capital? For debt, this is the interest rate paid on the company’s bonds. You also need the corporate tax rate to take into account the interest rate tax shields that come with debt financing.
For equity, this is the company’s cost of equity, which can be determined using the CAPM formula discussed above. It represents the rate of return shareholders require, and is generally higher than the cost of debt.
Once you have these figures, you can use the following formula to calculate the company’s WACC:
WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Debt x Cost of Debt) x (1 – Corporate Tax Rate)
To understand how WACC works, let’s take the example of a company that has $500 million in debt, with an interest rate of 5%, and $500 million in equity, with a cost of equity of 10%. The corporate tax rate is 20%.
Therefore, the value of the company is $1 billion. Why? Because it is the sum of debt plus equity, which corresponds to the value of the firm’s assets.
To calculate the company’s WACC, we calculate the proportion of each source of capital in the total capital structure. In this case, the proportion of debt is 50% ($500 million / $1 billion) and the proportion of equity is also 50% ($500 million / $1 billion).
Now we just need to plug all the information into the formula to get the company’s WACC of 7%:
(50% x 10%) + (50% x 5%) x (1 – 20%) = 7%
An investor can use this WACC as a discount rate to evaluate company projects with similar risk to its existing operations.
It’s important to note that these formulas are just a starting point, and there are many variations and adjustments investors make depending on the specific situation.
However, by understanding the basic steps involved in calculating CAPM and WACC, you learn how to use them in your analysis.
CAPM vs WACC
So, what is the key difference between CAPM and WACC? There are a few. Here’s a quick breakdown:
- CAPM focuses on the expected return on an investment, while WACC focuses on a company’s cost of capital.
- Investors use CAPM to estimate the appropriate rate of return on investments, while companies use WACC to determine the cost of capital for their business.
- CAPM is based on the premise that the expected return on a security is equal to the risk-free rate of return plus a risk premium, while WACC looks at the cost and weight of debt and equity over the total value of the company.
In short, CAPM and WACC are two different tools that serve different purposes. However:
CAPM can be used to calculate the cost of equity present in the WACC calculation.
CAPM vs WACC Frequently Asked Questions
Is WACC better than CAPM?
It is not accurate to say that one is better than the other, as they serve different purposes in finance. CAPM is a tool you use to determine an investment’s expected return, while WACC is a measure of a company’s total cost of capital. Both are important tools for financial analysis, and which one is more relevant or useful depends on the specific situation.
Does CAPM give WACC?
You can use the CAPM to estimate the cost of equity used in the WACC calculation. However, CAPM and WACC are two separate tools that serve different purposes in finance, and thus CAPM does not give WACC.
When should CAPM be used?
You should use the CAPM to compare the potential returns of different stocks given their level of risk and to make more informed investment decisions. CAPM is typically used in conjunction with other financial analysis techniques, such as discounted cash flow analysis, or the WACC (serving as the cost of equity).