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Finance Strategy for Investors

This document provides an example of calculating the weighted average cost of capital (WACC) using the capital asset pricing model (CAPM). It first shows how to calculate the cost of equity using CAPM, which is the risk-free rate plus a risk premium rate that is the market risk premium multiplied by beta. It then defines the components used to calculate WACC, which is a weighted average of the cost of equity and cost of debt. Finally, it provides an example calculation that results in a WACC of 17.1%. The document also gives an example of calculating the cost of equity for a specific project using a market-derived value (MDV) and a project-specific premium, resulting in a cost of equity

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222 views3 pages

Finance Strategy for Investors

This document provides an example of calculating the weighted average cost of capital (WACC) using the capital asset pricing model (CAPM). It first shows how to calculate the cost of equity using CAPM, which is the risk-free rate plus a risk premium rate that is the market risk premium multiplied by beta. It then defines the components used to calculate WACC, which is a weighted average of the cost of equity and cost of debt. Finally, it provides an example calculation that results in a WACC of 17.1%. The document also gives an example of calculating the cost of equity for a specific project using a market-derived value (MDV) and a project-specific premium, resulting in a cost of equity

Uploaded by

ekaarinatha
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© © All Rights Reserved
We take content rights seriously. If you suspect this is your content, claim it here.
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Download as PDF, TXT or read online on Scribd
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ExampleCapitalAssetPricingModel(CAPM)andWeightedAverageCostof

Capital(WACC)
CAPM

Ke=Rf+Rp
Rp=betax(RmRf)
where:
Keisthecostofequitycapital
Rfisthe"riskfree"rate
Rpisthe"riskpremium"rate
(beta)isthemeasureofsystematicrisk
Rmisthereturnrateofamarketbenchmark,liketheS&P500.

Rf=RiskfreeRate

5%

(beta)=measureofsystematicrisk

1.25

Rm=Proportionofequityincapitalstructure 12%

Rp=betax(RmRf)=1.25(12.0%5%)=8.75%
Ke(aftertax)=Rf+Rp=6.0%+8.75%=14.75%
Ke(pretax)=14.75%/[1.35]=22.7%

WACC = (k e We ) + (k d [1 t ] Wd )
WACC
where:
WACC = Weightedaveragecostofcapital
= Costofequitycapital
ke
kd
= Costofdebtcapital
We
= Percentageofequitycapitalinthecapitalstructure
Wd
= Percentageofdebtcapitalinthecapitalstructure
t
= Companyseffectiveincometaxrate
Assume:
Kd=Costofdebtcapital
6%
We=Proportionofequityincapitalstructure 70%
Wd=Proportionofdebtincapitalstructure 30%
Incometaxrate
35%

Keycare
Strategy Operations Technology
www.keycare.ca

WACC=(22.7%x0.7)+(6%[10.35)]x0.3)=17.1%

TheoverallCAPM&WACCcostofequitycapitalintheaboveexample:17.1%.
ExampleProjectCostofEquityCapitalusingMDVandProjectPremium
EquityInvestorsTotalRequiredReturn=MDV+Pp
MDV=Rsi+Rdp+Evp Rsi=4.0%;
Rdp=2.5%; Evp=11.0%.
Rsiisthesovereigninflationrisk
Rdpisthedefaultriskpremium
Evpistheearningsvolatilitypremium Ppistheprojectpremium

A B C
Criteria(putonlyoneineitherA,BorC)
CompanySpecificCriteria

Relationofcompanytoproject:integraterelevantmanagement


systems
Relianceonandimpactofsuccessthatinfluencesordictatefuture


choicesofcompany
Historicalinformationandreview:corporatesuccessesandfailures,


corporatestrengths,otherprojectdevelopmentaccomplishments
Budgetconstraints


Entrepreneurialnatureofcompany

Comparablescompanyandindustriesassessment


Managerialoptions


ProjectSpecificCriteria

Documenteddetailedprojectdevelopmentstudiesandplans


Documentedanalyticalreview:product,schedule,andcosts


Trained,qualifiedandexperiencepersonnel(bewareexcessive


relianceonselectindividuals)
Projectmanagementsupervisionandcontrols


Qualitymanagementsupervisionandcontrols

Uniqueaspectsofprojecte.g.sourcesofvalue;spillovereffects


Financial

Documentedsalesforecasts


DCFvaluationwithproperriskadjusteddiscountrateandsensitivity


analysis(positiveNPVrule)
RankingSelection:AAboveAverage

BBaseline
CConcern

ProjectPremiumAdditionalAdjustmenttoDiscountRate
ProjectPremiumPp
ProjectPremiumPp
Ranking
Additionaldiscountriskadjustment%

Keycare
Strategy Operations Technology
www.keycare.ca

A
0
B
EqualtoMDVRdp
C
EqualtoMDVEvp

ProjectPremium=Pp=additionaladjustmenttodiscountrate=MDVRdp=2.5%

MDV=Rsi+Rdp+Evp=(4.0+2.5+11.0+2.5)=20.0%

TheMCPM&ProjectPremiumcostofequitycapitalintheaboveexample:20.0%

Keycare
Strategy Operations Technology
www.keycare.ca

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