CAPM vs. WACC

Difference Between CAPM and WACC

Assessment of shares is important for investors and financial experts. While there are investors who expect a certain rate for their investment in shares of a company, there are holders as well as lenders of equity in any company who want their investments to yield good returns. The different statistical tools are available for these purposes and the CAPM and WACC are very popular. There are many differences in these two instruments as readers learn after going through this article.

CAPM is the Capital Asset Pricing Model. This is a process to discover the correct price of a stock or about any capital using projections of cash flow in future and a risk adjusted discounted rate.

Every Company has its own strategies for future cash flow, but investors must find the real value of future cash flows from the perspective of today’s market. This requires assessment of the discount rate to find the net present value of cash flow or NPV. There are many ways to discover the fair value of the price of capital of a company and one of them is WACC (weighted average cost of capital). Every company knows the price (interest rate) they pay for the debt it has taken to raise the capital, but it must calculate the price of equity which is includes debt and money shareholders. The shareholders also expect a decent rate of return on their investment in a company or they are willing to sell the equity they possess. The price of equity is that it takes for a company to maintain share prices at a high level (good for shareholders). CAPM gives the price for equity which is calculated by below mentioned formula.

r = rf X b (rm – rf)=CAPM. This is the formula for cost of equity

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 capital.

The Weighted Average Price of Capital (WACC) is based on the proportion of debt and equity in the entire capital of a company.

WACC = the D XE / V x Rd (1-tax rate on corporations) XD / V

Where D / V is the ratio of debt to the company’s total value (debt equity)

E / V is the ratio of equity to the total of the company (debt equity)

 

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