Series 79: Cost Of Equity For WACC Calculation: Capital Asset Pricing Model (CAPM)

Cost of Equity for WACC Calculation: Capital Asset Pricing Model (CAPM)

You might wonder how to determine a company’s cost of equity for purposes of calculating WACC. Typically, an investment banker will look to a formula called the capital asset pricing model, or CAPM. The calculation for cost of equity using CAPM is:

cost of equity = risk-free rate of return + (beta x market risk premium)

The risk-free rate of return is the expected rate of return of investing in U.S. Treasuries or other so-called risk-free investments. Beta, as previously discussed, is a measure of a stock’s volatility relative to the overall market. The market risk premium is the difference between the risk-free rate of return and the expected market return. An example of CAPM is in order.

Example: Assume the risk-free rate of return is 1% and that the company’s equity has a beta of 1.1 (i.e., somewhat more volatile than the market as a whole). The expected market rate of return is 8%. In this example, the market risk premium is 7%