CAPM vs WACC
Share valuations are a must for every investor as well as financial expert. While there are investors who are expecting certain rate for their investment in shares in a company, there are lenders and equity holders in a company who also expect decent returns on their investments in a company. Various statistical tools are available for these purposes, and out of these CAPM and WACC are very popular. There are many differences in these two tools as readers would find out after going through this article.
CAPM stands for Capital Asset Pricing Model which is a method to find out the correct price of a stock or just about any asset using future cash flow projections and a discounted rate which is risk adjusted.
Every company has its own projections for cash flow for the next few years, but investors need to figure out the real worth of these future cash flows in terms of today’s market. This requires calculating a discount rate to come up with the Net Present Value of cash flows, or NPV. There are many methods to find out the fair value of the cost of capital of a company, and one of these is WACC (weighted average cost of capital). Every company knows the price (rate of interest) that it pays for the debt it has taken to raise the capital, but it has to calculate the cost of the equity that is made up of both debt as well as shareholders money. Shareholders also expect a decent rate of return on their investment in a company or else they are ready to sell the equity they are holding. This cost of equity is what it takes for a company to maintain share price at a good level (satisfactory for shareholders). It is this cost of equity that is given by CAPM and is calculated using the following formula.
Cost of Equity using CAPM = r= rf + b X ( rm – rf)
Here rf is the risk free rate, rm is the expected rate of return on the market and b (beta) is the measure of relationship between risk factor and the price of asset.
Weighted Average Cost of Capital (WACC) is based upon the proportion of debt and equity in the total capital of a company.
WACC = Re X E/V + Rd X (1- corporate tax rate) X D/V
Where D/V is the ratio of company’s debt to total value (debt + equity)
E/V is the ratio of company’s equity to company’s total (equity +debt)