Question

how do you derive the cost of equity in the WACC formula? please critically comment in particular on the CAPM formula in this context ?

Answer 1

Cost to company means the rate of return that the investor gets or expects. WACC formula assigns weights to each stock that the company has while calculating the cost of capital. Because it takes into consideration both weights and rate of interest (cost) , the rate arrived at would be more realistic.

For example, let us assume that the company's equity consists of 40% retained earnings, 25% preferred stocks and 35% equity shares. cost of preferred stock is 8% and cost of equity shares is 10%. As per WACC formula, the cost of equity would be (0.4 * 0.1) + (0.25 * 0.08) + (0.35 * 0.1)

= 0.04 + 0.02 + 0.035

= 0.095 = 9.5% which is the weighted average cost of capital.

(ii) Capital Asset Pricing Model (CAPM) formula is R_i = R_{f +} (R_m - R_f) β_i

Here, "R_f " is the risk free rate of return which the investor gets by investing in stocks like government securities where a fixed rate of return is guaranteed and investment is not at risk.

"(R_m - R_f)" stands for risk premium. It is the extra return for taking additional risk by the investor over and above the risk free rate of return.

"β_i " is the statistical measure. It represents the sensitivity of company's stock to the change in market. Market β is considered as 1. β_i represents for every 1% change in market how much the stock of company changes.

Thus we can say CAPM takes into consideration both time value of money and risk. Where R_f represents time value of money, other indicators in the formula factors the risk involved.