THE USE OF WACC AND CAPM AS A

MODEL /TOOL OF INVESTMENT ANALYSIS

2ND DECEMBER 2023

Abstract

This term paper explores the integral role of the Weighted Average Cost of Capital (WACC) and

the Capital Asset Pricing Model (CAPM) as critical tools in investment analysis. Beginning with

an examination of the capital structure's importance, the paper delves into the distinct

components and formulas of WACC and CAPM. Using practical examples, including the

calculation of WACC for a hypothetical company (UPBS) and the expected return determination

using CAPM for a high-risk tech start-up, the paper illustrates the real-world application of these

models. The applications of WACC in investment analysis, encompassing discounting future

cash flows, evaluating investment opportunities, optimizing capital structure, and assessing risk,

are explored. Similarly, the applications of CAPM, ranging from estimating cost of equity to

portfolio management and performance evaluation, are discussed. The paper concludes by

emphasizing the interconnectedness of WACC and CAPM, forming a comprehensive framework

for evaluating investment opportunities and making informed financial decisions. This

exploration contributes to a deeper understanding of these tools' significance in navigating the

complexities of the investment landscape.

The financial landscape of a company is intricately woven with the composition of its capital

structure, delineating the proportion of debt and equity that sustains its operations. As investors,

managers, or financial analysts, encounters with terminologies such as the Weighted Average

Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM) are not uncommon.

While distinct in their applications, these financial models share a symbiotic relationship,

offering valuable insights into the viability and attractiveness of potential investments.

This term paper embarks on an exploration of the fundamental concepts of WACC and CAPM,

unraveling their individual significance and collectively, their impact on the realm of investment

analysis. Before delving into the intricacies of these models, it is crucial to acknowledge the

foundational importance of a company's capital structure. This structure, the amalgamation of

debt and equity, provides the bedrock for the subsequent analysis facilitated by WACC and

CAPM.

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WACC, a pivotal concept in financial analysis, serves as a barometer for a company's average

cost of capital, accounting for diverse sources such as common and preferred stock, bonds, and

other forms of debt. Its formula, dissecting the costs of each component and weighting them by

their presence in the capital structure, provides a holistic view of a company's financial health

and performance.

Conversely, the Capital Asset Pricing Model (CAPM) emerges as a tool for estimating the

expected return on investments, grounded in the assessment of systematic risk. This model,

encapsulated in a formula interlinking the risk-free rate, expected market return, and beta, not

only calculates the cost of equity but also finds its place as a crucial component in the broader

framework of WACC.

As we journey through the subsequent sections, we will unravel the practical applications of

WACC and CAPM, from discounting future cash flows to evaluating investment opportunities,

optimizing capital structure, and assessing risk. Each model plays a unique role in steering

investment decisions, and together, they create a comprehensive framework for financial

analysis. The synergy between WACC and CAPM underscores their collective utility in

navigating the complexities of the investment landscape, providing a nuanced understanding that

goes beyond the surface of financial metrics.

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2.0 Weighted Average Cost of Capital (WACC)

The Weighted Average Cost of Capital (WACC) is a key concept in financial analysis that

represents a company's average cost of capital from all sources, including common stock,

preferred stock, bonds, and other forms of debt. It is a crucial tool for evaluating the financial

health and performance of a company.

Weighted Average Cost of Capital, measures a company’s cost of capital. It is calculated by

considering the proportion of each source of capital used to finance the business (debt and

equity) and its cost.

To calculate WACC, you need to first determine the proportion of debt and equity in the

capital structure of the company. How much of the company’s assets are financed by debt

and how much is financed by equity? This is usually stated in the company’s financial

statement.

Next, what is the cost of each source of capital? For debt – interest, the cost of equity can be

determined using the CAPM formula, It represents the rate of return shareholders require.

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The formula for WACC is as follows:

• WACC = (Proportion of Equity x Cost of Equity) + (Proportion of Debt x Cost of Debt) x

(1 – Corporate Tax Rate)

• WACC = E/V × Re + D/V × Rd × (1−Tc)

• Where:

• E is the market value of equity,

• D is the market value of debt,

• V is the total market value of the firm's capital structure (E+D),

• Re is the cost of equity,

• Rd is the cost of debt,

• Tc is the corporate tax rate,

2.1 WACC Example

To understand how WACC works, let’s take this as example;

UPBS has N500 million in debts, with an interest rate of 5%, and N500 million in equity,

with a cost of equity of 10%. The corporate tax rate by the Nigeria government is 20%.

Therefore, the value of the capital structure of UPBS is N1 billion. This is because it is the

sum of debt plus equity, which corresponds to the value of the firm’s assets.

To calculate the UPBS WACC, we calculate the proportion of each source of capital in the

total capital structure. In this case, the proportion of debt is 50% (N500 million / N1 billion)

and the proportion of equity is also 50% (N500 million / N1 billion).

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 Now we just need to plug all the information into the formula to get the company’s WACC

of 7%:

(50% x 10%) + (50% x 5%) x (1 – 20%) = 7%

2.2 Application of WACC (Weighted Average Cost of Capital)

A. Valuation: WACC is crucial in discounted cash flow (DCF) analysis for valuation

purposes. By discounting future cash flows at the company's WACC, analysts can

determine the present value of expected future earnings and investors can assess the

potential profitability of an investment.

B. Project Evaluation: WACC is used to assess the feasibility of new projects or

investments. It helps in comparing the expected return from a project with the company's

overall cost of capital. If the expected return on an investment exceeds WACC, it is

considered a worthwhile undertaking while investments yielding returns below WACC

may be considered value-destructive.

C. Capital Budgeting: WACC is employed in capital budgeting decisions to evaluate

whether the returns from a proposed investment exceed the cost of financing it, aiding in

effective allocation of capital.

D. Mergers and Acquisitions: WACC is utilized to determine the cost of capital for both

the acquiring and target companies. This information is essential in assessing the

financial viability of mergers and acquisitions.

E. Optimizing Capital Structure: WACC plays a critical role in determining the optimal

capital structure for a company. By balancing the use of debt and equity financing,

companies can minimize their overall cost of capital and maximize shareholder value.
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 F. Risk Assessment: WACC reflects the riskiness of a company's capital structure, as it

considers the different risk profiles of debt and equity financing. Investors can use

WACC to assess the overall risk associated with an investment and make informed

decisions.

3.0 The Capital Asset Pricing Model (CAPM)

The Capital Asset Pricing Model (CAPM) is a tool you can use to determine the expected return

on a given investment. This investment can be a stock, bond, some other security, or a project. It

is a tool investors use to determine the expected return on an investment, CAPM is based on the

risk-free rate of return and a risk premium.

The main idea behind CAPM is that the expected return on a security is equal to the risk-free rate

of return plus a risk premium. The higher the risk, the higher the potential return. This financial

model that estimates the expected return of an asset based on its systematic risk, also known as

beta. It is a widely used tool for calculating the cost of equity, which is a component of WACC.

CAPM Formula

To compute the CAPM, you need to first determine the risk-free rate of return. This is typically

the coupon on a government bond from an established country like the United States, or

Germany. Why? Because these are considered the safest investments you can make.

Next, you need to determine the expected return on the market as a whole. To do this, you can

look at the historical returns of a market index, such as the S&P 500.

Lastly, you need the Beta of the security whose expected return you’re trying to compute. This is

a measure of the stock’s volatility relative to the market.

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CAPM establishes a linear relationship between the expected return on an investment and its

systematic risk, represented by beta (β).

The formula for CAPM is as follows:

Expected Return = Risk-Free Rate + Beta x (Market Return – Risk-Free Rate)

Re = Rf + β × (Rm – Rf)

Where:
 Re is the expected return on equity,
 Rf is the risk-free rate,
 Rm is the expected market return.

3.1 CAPM Example

• Let’s say you want to invest in a high-risk tech start-up. Using the CAPM, you can

determine the expected return on this investment by taking into account the risk-free rate

of return and the beta of the start-up. If the risk-free is 3%, the expected return for the

S&P 500 is 8%, and the beta of the company is 2, then its expected return is 13%:

• 3% + 2 x (8% – 3%) = 13%

3.2 Applications of CAPM in Investment Analysis

A. Estimating Cost of Equity: CAPM is the primary method for estimating the cost of

equity for publicly traded companies. CAPM is used to estimate the required rate of

return for individual securities or entire portfolios, aiding in investment decision-

making. It considers the risk-free rate, market risk premium, and beta to quantify the

required return for equity investors. By considering the market risk of the company's

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 stock, CAPM provides a benchmark for evaluating the expected return on equity

investments.

B. Portfolio Diversification: CAPM is used to assess the impact of adding a particular

asset to an investment portfolio. By considering the asset's beta and the portfolio's

overall beta, investors can make informed decisions about portfolio diversification

and risk management.

C. Performance Evaluation: CAPM can be employed to evaluate the performance of a

portfolio relative to a market benchmark, such as the S&P 500. By comparing the

portfolio's return to its expected return based on CAPM, investors can assess the

effectiveness of their investment strategy. CAPM helps investors and analysts assess

the expected return of an investment in relation to its risk, allowing for better risk

management.

D. Assessing risk: The CAPM incorporates the concept of beta, which measures an

asset's sensitivity to market movements. By calculating an asset's beta, investors can

assess its systematic risk, which cannot be diversified away. This allows investors to

evaluate the riskiness of an investment and determine if it aligns with their risk

tolerance.

E. Cost of capital estimation: The CAPM is used in corporate finance to estimate the

cost of equity capital. It helps companies determine the appropriate discount rate to

evaluate investment projects and make capital budgeting decisions.

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 F. Investor Decision-Making: Investors use CAPM to evaluate the attractiveness of

individual stocks or investment opportunities. It aids in making informed decisions by

considering the risk-return profile of different assets.

G. Market Consistency: CAPM provides a consistent framework for assessing the

required return across different investments, facilitating comparisons and decision-

making in the context of the broader market.

4.0 Integration of WACC and CAPM

 Comprehensive Risk Assessment: While WACC provides a holistic view of a

company's cost of capital, CAPM drills down into the specific risk associated with equity.

Integrating both models offers a more comprehensive risk assessment for investment

decisions.

 Strategic Decision-Making: Together, WACC and CAPM guide strategic decisions

regarding financing, investment, and risk management. This integration ensures a

cohesive approach to aligning financial strategies with organizational goals.

 In essence, WACC and CAPM, when used in conjunction, create a robust framework for

evaluating investment opportunities, making strategic financial decisions, and optimizing

the overall cost of capital for sustainable growth.

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5.0 Limitations of WACC, CAPM, and Mitigation Strategy

Financial valuation models, such as the Weighted Average Cost of Capital (WACC) and the

Capital Asset Pricing Model (CAPM), are essential tools in finance. However, a critical

examination of their limitations and the exploration of effective mitigation strategies are crucial

for accurate financial decision-making.

5.1 Limitations of WACC

A. Assumption of Constant Capital Structure

The assumption of a constant capital structure in WACC, as challenged by Modigliani

and Miller (1958), oversimplifies the financial reality where companies actively manage

their leverage. This oversimplification can lead to misestimations of the firm's cost of

capital.

Modigliani and Miller's groundbreaking research suggests that, under certain conditions,

capital structure decisions should not impact a firm's overall value. However, in the real

world, firms often adjust their financial leverage based on factors such as tax

considerations, industry norms, and economic conditions. For example, during economic

downturns, companies might reduce debt levels to minimize financial risk.

B. Risk-Free Rate and Market Risk Premium Assumptions

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 Fama and French (2004) critique the reliance on subjective estimates for the risk-free rate

and market risk premium in WACC calculations. This introduces potential biases,

impacting the reliability of financial decision-making.

The risk-free rate, often derived from government bonds, may not precisely reflect the

time value of money due to factors like inflation expectations. For instance, if inflation

expectations are not accurately factored into the risk-free rate, it can lead to an

overestimation or underestimation of the true cost of capital. Additionally, the market risk

premium, a key determinant in WACC calculations, is subject to varying interpretations

and assumptions.

C. Inclusion of Historical Costs

Myers (1984) emphasizes that WACC's inclusion of historical costs may not accurately

represent the current market conditions, especially during periods of financial distress or

rapid changes in interest rates.

Using historical costs for debt and equity in WACC calculations assumes that these costs

remain constant over time. However, during economic turbulence, interest rates may

change rapidly, impacting the true cost of debt. For example, a company with debt issued

at fixed interest rates during a period of low-interest rates might face higher borrowing

costs when refinancing in a high-interest-rate environment.

Mitigation Strategies for WACC

A. Dynamic WACC:

A dynamic WACC approach, as proposed by Harris and Raviv, involves recognizing the

evolving nature of a firm's capital structure. By adjusting discount rates to reflect changes

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 in financial leverage over time, this approach aligns more closely with the dynamic

realities of financial decision-making.

Example

Consider a tech startup that initially relies heavily on equity financing but transitions to

debt financing as it matures. Dynamic WACC allows for adjustments in discount rates to

capture this shift in capital structure, providing a more accurate reflection of the firm's

cost of capital.

B. Regular Review of Inputs:

Regularly reassessing and updating WACC inputs, as recommended by Brealey, Myers,

and Allen, ensures that the model remains reflective of current market conditions. This

involves adjustments to risk-free rates and market risk premiums based on the latest

economic indicators.

Example:

During economic downturns, central banks may lower interest rates to stimulate

economic activity. Regularly reviewing and adjusting the risk-free rate in WACC

calculations during such periods ensures that the model captures these changes and

provides more accurate cost of capital estimates.

5.2 Limitations of CAPM

A. Sole Reliance on Beta

The reliance on beta as the sole measure of systematic risk in CAPM, as highlighted by

Black (1972), may not capture all relevant risk factors, particularly in markets with non-

linear relationships.

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 Beta, representing a stock's sensitivity to market movements, assumes a linear

relationship between a stock's returns and overall market returns. In reality, markets often

exhibit nonlinear behaviors, such as during financial crises, where correlations among

asset classes may change rapidly.

B. Assumption of Constant Beta

Scholes and Williams (1977) critique CAPM's assumption of a constant beta,

emphasizing that beta can vary over time. This challenges the model's accuracy in

reflecting changes in a company's risk profile.

The assumption of a constant beta may not hold in dynamic market conditions. For

instance, a company's beta may change due to shifts in its business model, industry

dynamics, or overall market conditions.

C. Market Risk Premium Challenges

Mehra and Prescott (1985) raise concerns about the rationality of estimating the market

risk premium, suggesting that historical equity premiums might not accurately predict

future expectations, impacting the reliability of CAPM.

Estimating the market risk premium involves predicting the excess return of the market

over the risk-free rate. Changes in investor sentiment, economic conditions, or

geopolitical events can influence future expectations, making it challenging to rely solely

on historical data.

Mitigation Strategies for CAPM

A. Consider Multiple Models:

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 Fama and French's three-factor model expands CAPM by considering additional risk

factors beyond the market beta, providing a more comprehensive framework for

estimating expected returns.

Example:

Incorporating factors such as a company's size and value characteristics alongside market

beta allows for a more nuanced understanding of systematic risk. For instance, small-cap

stocks may exhibit different risk-return profiles compared to large-cap stocks.

B. Sensitivity Analysis:

Conducting sensitivity analysis, as emphasized by Sharpe, involves assessing the impact

of variations in key inputs, such as the risk-free rate and market risk premium, on CAPM

outputs. This enhances understanding of the model's robustness.

Example:

In a sensitivity analysis, one could vary the risk-free rate to understand how changes in

this parameter affect the expected return estimates. This helps analysts and decision-

makers gauge the model's reliability under different economic scenarios.

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6.0 Conclusion

The Weighted Average Cost of Capital (WACC) and the Capital Asset Pricing Model (CAPM)

are essential tools for evaluating investment opportunities and making informed financial

decisions. While both models have their limitations, their combined use provides a

comprehensive framework for assessing risk and return, optimizing capital structure, and

achieving long-term financial goals.

In navigating the complexities of financial valuation, an in-depth understanding of the limitations

inherent in models such as the Weighted Average Cost of Capital (WACC) and the Capital Asset

Pricing Model (CAPM) is paramount. The challenges are posed by assumptions like constant

capital structure and reliance on specific parameters.

Mitigation strategies, grounded in influential works by financial theorists, offer practical avenues

for refining these models. A dynamic approach to WACC, acknowledging the evolving nature of
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a firm’s capital structure, aligns with the dynamic realities of financial decision-making.

Regularly reviewing and updating inputs, as recommended by prominent financial thinkers,

enhances the accuracy of WACC calculations.

Similarly, in CAPM, the pitfalls associated with sole reliance on beta and the assumption of a

constant risk profile prompts the consideration of multifaceted models. Fama and French’s three-

factor model, incorporating size and value characteristics, broadens the scope of CAPM, while

sensitivity analysis, as advocated by Sharpe, ensures a robust understanding of the model’s

dynamics.

By critically examining these models, acknowledging their limitations, and embracing

sophisticated strategies for refinement, financial practitioners can cultivate a more nuanced and

accurate approach to valuation.

The interplay between WACC and CAPM extends beyond investment analysis, influencing

strategic financial planning, capital management, and the overall financial health of an

organization. By understanding and addressing the limitations of each model, investors, financial

analysts, and corporate decision-makers can harness the power of WACC and CAPM to drive

sustainable growth and value creation.

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 References

 Black, F. (1972). "Capital Market Equilibrium with Restricted Borrowing." The Journal

of Business.

 Brealey, R. A., & Myers, S. C. (2010). Principles of corporate finance (11th ed.).

McGraw-Hill/Irwin.

 Fama, E. F., & French, K. R. (2004). "The Capital Asset Pricing Model: Theory and

Evidence." Journal of Economic Perspectives.

 Eugene F.Brigham Michael C. Ehrhardt “Financial Management Theory and Practice”

13th Edition Pg. 337-349

 Harris, M., & Raviv, A. (1991). "The Theory of Capital Structure." The Journal of

Finance.

 Mehra, R., & Prescott, E. C. (1985). "The Equity Premium: A Puzzle." Journal of

Monetary Economics.

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 Modigliani, F., & Miller, M. (1958). "The Cost of Capital, Corporation Finance and the

Theory of Investment." The American Economic Review.

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 Scholes, M., & Williams, J. (1977). "Estimating Betas from Nonsynchronous Data."

Journal of Financial Economics.

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Conditions of Risk." The Journal of Finance.

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