Estimating the cost of equity vs the cost of all capital sources
In short:
The difference between weighted average cost of capital (WACC) and the capital asset pricing model (CAPM) is that WACC is used to calculate the blended average of all a firm’s capital sources, whereas, CAPM is used to calculate the cost of a firm’s equity (ownership).
For a company, the value of WACC is to know their hurdle rate which represents the minimum return a project must generate in order to be considered.
Key Points
- The weighted average cost of capital (WACC) represents the cost of all sources of a company’s capital.
- The capital asset pricing model (CAPM) is a risk/reward model that can be used to estimate a company’s cost of equity.
- CAPM is often used within the WACC calculation to approximate the cost of equity but WACC is not used within CAPM.
- Equity is represented by common stock and preferred stock in publicly traded companies.
In-depth:
What is WACC
All companies need capital to fund their operations. Think about it, if you wanted to start a business you need money to buy equipment, pay for a place to operate out of, possibly pay people, etc. When it comes to getting this capital business owners have two possible options to source their capital from.
Option 1, they can pay for everything out of their own pocket and/or get investors to give them money in exchange for some ownership. This type of capital is called equity (ownership) and is almost always the most expensive form of capital.
For large companies, equity can either be common stock or preferred stock. The “cost” is the expected return for the equity, i.e. common or preferred stock.
Option 2, the other possible source of capital is debt. Instead of funding all of the operations out of the owner’s pocket, they can borrow money for the business operations which would be using debt. Debt is almost always the cheaper form of capital up to a certain point but it adds risk to the business.
For large companies, debt can either be banknotes or bonds. The “cost” is the interest rate the company pays on the debt.
So where does the weighted average cost of capital (WACC) come in? WACC is used when a combination of both debt and equity are used to source the capital for a company. Since both debt and equity will have different costs associated with them, we need to have a calculation to figure out how much our capital costs.
Here is the formula for WACC:
What is CAPM
Intuitively, the weighted average cost of capital (WACC) is a pretty straightforward concept as it represents the weighted average of a company’s funding costs. Often, however, when it comes to calculating the components that go into the WACC calculation things get a bit more challenging specifically with equity.
Unlike debt, equity doesn’t come with any promised returns so it is harder to know what its costs are. Because of this, companies and investors who want to calculate WACC must have a method for accurately estimating the cost of equity.
The most popular method for estimating the cost of equity is to use the capital asset pricing model (CAPM) for two reasons.
The first reason, CAPM is relatively simple yet flexible and can incorporate the risk of the company vs the risk of the general market.
The second reason, equity investors often use this model to calculate the minimum return on investment they should require in order to own shares in a company.
Here is the CAPM formula:
WACC vs CAPM Uses
An important distinction to make between WACC and CAPM are their uses.
Uses for WACC
- The hurdle rate for company projects
- The discount rate for future cash flows of companies in discounted cash flow analysis
Uses for CAPM
- Calculating an investor’s expected return for ownership interest in a company.
- Calculating the cost of equity for a company
Frequently Asked Questions
WACC is better to use if a project has a similar risk and financing profile to the business considering the project. If the project has a significantly different risk profile or uses primarily equity, CAPM is better to use.
WACC is calculated with the formula: WAC = [ % Equity x Cost of Equity ] + [ % Preferred x Cost of Preferred ] + [ % Debt x Cost of Debt x (1 – Tax Rate) ]. CAPM is used to calculate the cost of equity which is used in the WACC formula.
CAPM does not give you WACC since CAPM is a separate formula whose value (cost of equity) can be used in the WACC formula.