WACC and the Capital Asset Pricing Model
- Author Adam Fish
- Published July 14, 2011
- Word count 403
The concept of a discounted cash flow analysis is simple: we forecast the company's free cash flows and then discount them to the present value using the company's weighted-average cost of capital (WACC). Calculating WACC, however, can be a bit more complicated. Let's take a closer look at how it is done.
The weighted average cost of capital or WACC represents weighted average price a company must pay for debt or equity capital. The formula for WACC is straightforward:
WACC = Cost of Debt * Debt / (Debt + Equity) + Cost of Equity * Equity / (Debt + Equity)
The weightings of capital in this equation are very easy to calculate based on the company's current balance sheet. The cost of debt is a little more involved, but pretty straightforward, but the cost of equity calculation can be difficult.
For a company with publicly traded debt, you would need to look up the current yield to maturity for each piece of debt that it has outstanding. You would also need to look at the rate paid on each piece private debt on the company's balance sheet. You then take the weighted average of all these yields and rates to come up with company's cost of debt.
Cost of Equity
The cost of equity in a WACC computation can be represented by the capital asset pricing model (CAPM):
Ke = Rf + Beta (market risk premium) + (other company-specific premiums)
In this equation, Ke is the cost of equity and Beta is a measure of how the value of a company moves with respect to the value of the overall market. The market risk premium is the premium that investors demand to invest in the stock market versus the U.S. treasury market. Other premiums might include a "small cap premium" or a "private company premium."
The market risk premium as well as other premiums are often taken from a source such as Ibbotson. In general the market risk premium is usually somewhere between 7 and 8%. The risk free rate is usually assumed to be a medium-term U.S. treasury yield (1-10 years).
Once you have pulled together these variables - many of which are available from sources such as Bloomberg or Yahoo Finance - you plug them into the CAPM formula to calculate the cost of equity. You can then plug the cost of equity into the WACC formula, and you now have a weighted-average cost of capital for a discounted cash flow analysis.
Want to look at a sample discounted cashflow model and explore a discounted cash flow analysis in more depth? Visit Finance Ocean. Or get ready for a job interview with practice interview questions and answers.
Article source: https://articlebiz.comRate article
Article comments
There are no posted comments.
Related articles
- Moody Vibes Only: Statement Pieces
- The King Beyond the Spotlight: Unveiling the True Elvis Presley.
- Where Soul Meets Space: Curating with Character
- Cinematic Titans: Inside the Billion-Dollar Club.
- Attention-Grabbing Dating Profile Headlines for Singles Over 40
- Digital Transformation: How to?
- Jaws: Beneath the Surface — Fear, Fragility, and the Monsters We Carry.
- 🚤 Pattaya Floating Markets & Hotels: The Best of Local Culture & Comfort
- 🏝️ Koh Mai Phai: Bamboo Island Adventures in Thailand's Andaman Sea
- 🏋️♂️ Top Gyms in Pattaya
- 🏝️ Koh Kood, Thailand: An Underrated Island Paradise + Must-Try Tropical Fruits
- 🌴 Exploring Phi Phi Island: What to Do & How to Get There
- 🌴 Things to Do in Pattaya: Water Parks for Kids & Markets for Adults
- ✅ How to Find the Ideal Tour Guide in Thailand
- Essential Thai Phrases Every Tourist Should Know 🇹🇭
- Choosing the Right Hotel in Pattaya: What to Consider Before You Book
- Best Hotels to Stay at in Bangkok (2025 Guide) – Where Comfort Meets Culture
- Best Hotels on Pattaya Beach (2025 Guide): Where to Stay for Views, Vibes & Value
- Best Time of the Year to Visit Pattaya, Thailand: A Month-by-Month Guide
- Enjoying a Comfortable Flight to Thailand: Tips for a Smooth Journey
- Can Foreigners Own Land in Thailand? Here's What You Need to Know (2025 Update)
- New Entry Requirement: Thailand Digital Arrival Card (TDAC)
- West Side Story: A Clash of Dreams and Realities in the Streets of New York.
- The Eternal Outsider: Peter O’Toole’s Journey from Theatre to Hollywood Legend.
- Tab Hunter: Hollywood’s Golden Boy and the Secret He Had to Hide.
- Kirk Douglas: The Indomitable Spirit of Hollywood’s Golden Age.
- The Antique Indian Door as an Artist’s Muse
- Majestic Portals: Styling Indian Palace Doors for Soulful Spaces
- Why Choose Professional Dementia Care Services in Mobile, AL?
- Mission: Impossible — The TV Classic That Redefined Espionage.