Question

Compare and contrast the followings investment techniques in terms of similarities and differences. Please discuss and elaborate. • WACC as seen in Corporate Finance textbook vs. WACC covered in VC Investment textbook • CAPM as seen in WACC as seen in Corporate Finance textbook vs. CAPM as covered in VC Investment textbook

Answer 1

WACC in corporate finance textbook and WACC in Vc investment textbook.

Similarities:

WACC stands for weightage average cost of capital. The calculation process of WACC is same, first find out the cost of equity and weight of equity in total capital then find out the after tax cost of debt and weight of debt in the total capital , multiply cost of equity with its respective weight and after tax cost of debt with its weight and sum these two. Then we get the weightage average cost of capital. The calculation process in corporate finance or for venture capital firms, both ways the process is same.

Difference:

For a company which is mature phase or generating cash flow, have traditional financial metrics, calculating WACC becomes easy, not a very dificult process. VC firms invest in early age companies or startups. for startups getting debt is very difficult thing because since there is no history of cashflow no financial institution is going to provide the funds to them easily. Startups rely on funding by VCs , PE-VC firms, hence WACC is not an appropriate criteria. They generally buy equity stake in these companies and at later stage if successfull sell out their stake, generating significant rate of return.

CAPM as seen in corporate finance textbook Vs. CAPM in VC investment book.

Similarities

CAPM stands for capital asset pricing model. CAPM is one of the ways through which the cost of equity is determined. Hence before calculating the weightage average cost of capital , we need to have the cost of equity, CAPM can be said to be a part of the pocess of WACC and this is applicable for both of them.To calculate the cost of equity through CAPM model, we need risk free rate, beta of the security, market rate of return.

Difference:

CAPM is more appropriate for companies whose stock price history is available to calculate the beta, and companies can easily access the market. This is not the case for the startups, for them very few funding opportunites are available because of their operating history. CAPM is not appropriate way to measure the cost of equity capital for venture capital investment because their investment carries high risk and high return opportunity.