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Christopher Batastini

Capital Asset Pricing Model (CAPM) represents the link between rate of return and of the risk for an investment (Byrd, Hickman, & McPherson, 2013). CAPM is based on the premise that investors are generally risk averse (Byrd et al., 2013). The higher the investment risk, the higher rate of return (or interest) will be demanded by investors. An example of this would be a person with a less than stellar credit history trying to buy a Toy-Hauler Recreational Vehicle. The lender would charge a higher interest rate based on the possibility that a payment will be missed or the customer may default all together.

The weighted average cost of capital (WACC) is a calculation of a firm's
cost of capital(Links to an external site.)
in which each category of capital is proportionately
weighted(Links to an external site.). All sources of capital, including common stock, preferred stock, bonds, and any other long-term debt, are included in a WACC calculation. (Hargrave, 2019). In other words, a company has various outstanding bonds, preferred stock and common stock that each has a differing cost to the company. By averaging, or blending, these costs, it allows a company to have a single WACC for the company’s capital portfolio. This provides an average cost of all sources of capital for a company.

The challenge for some financial managers in using CAPM is trusting in the components of the formula. The CAPM provides a formula that calculates the expected return on a security based on its level of risk. The formula for the capital asset pricing model is the risk-free rate plus beta times the difference of the return on the market and the risk-free rate. (N.A., 2019). When discussing risk free rate of return and market based risk versus risk rate of return, financial managers sometimes become leery of the concepts.

References

Byrd,J.,Hickman,K.,&McPherson,M.(2013). ManagerialFinance [Electronicversion].Retrievedfrom · ThistextisaConstellation coursedigitalmaterials(CDM)title

Hargrave, Marshall, (2019). Corporate Finance & Accounting Ratios,
Weighted Average Cost of Capital WACC
Retrieved From: https://www.investopedia.com/terms/w/wacc.asp

Christopher Fletcher

The capital asset pricing model assists in measuring risk and return as explained by Byrd, Hickman, and McPherson (2013) as “A formula that quantifies the connection between an investment's market risk and its required rate of return, specifically the required return on an asset equals the riskfree rate plus a risk premium. The risk premium is the asset's beta times the market risk premium.” Managers experienced difficulties with the original formulation in that it calls for use of the expected return on the market, which know one can know with certainty. In addition, “The model also assumes there is a single, observable risk-free rate, when in reality there is no investment free of risk and there is more than one possible rate that can be used as a close proxy for risk-free” (Byrd, Hickman, and McPherson 2013). Because of these issues, the formula currently used is as follows:

Required return for an investment = Rf + Beta(Market risk premium)

With long-term U.S. treasury bond yields used as the risk-free rate, and the market’s historical average used as the MRP.

Byrd, Hickman, and McPherson (2013) define the weighted average cost of capital as “The discount rate that may be found by incorporating the required returns (costs) for each capital source used to finance the firm.” An example of this is provided within the Hutchinson Unabridged Encyclopedia:

“if a company raises capital with £5 million of stock with an expected rate of return of 10% and £15 million of debt through a bond issue with a coupon of 5% the WACC is as follows: equity (£5 million) divided by total capital (£20 million) = 25% multiplied by cost of equity (10%) = 2.5% debt (£15 million) divided by total capital (£20 million) = 75% multiplied by cost of debt (5%) = 3.75% The two results added together give a WACC of 6.25%.”

Taking the CAPM and using the WACC to discount the project cash flows ensures that projects are only accepted if they provide the required returns.

The benefits of using the CAPM is that it is a widely accepted method of comparing risk vs. return between potential investment projects. The drawbacks are that the variables used to calculate CAPM are unknowable with certainty.

References

The Hutchinson Unabridged Encyclopedia with Atlas and Weather Guide. Helicon, 2018. Retrieved from
https://search-credoreference-com.proxy-library.ashford.edu/content/entry/heliconhe/weighted_average_cost_of_capital/0(Links to an external site.)?

Byrd, J., Hickman, K., & McPherson, M. (2013).Managerial Finance[Electronic version]. Retrieved from https://content.ashford.edu/