The world of finance and valuation is a mix of art and science where every variable utilized has its own significance and a discount rate or required rate of return is one of them. Weighted Average Cost of Capital (WACC) is the discount rate which is used in Discounted Cash Flow analysis which consists of two main components – Cost of Equity and Cost of Debt whereby weights are assigned to them as per the company’s capital structure. As estimation of costs is one of the critical analysis, Capital Asset Pricing Model (CAPM) is one of the approaches utilized to assess Cost of Equity.
CAPM is used to estimate the expected return from an investment as it delineates the relationship between the risk of a particular asset and its expected return. The model is based on the relationship between an asset’s beta, the risk-free rate and the equity risk premium (ERP) where Beta represents systematic risk which is the sensitivity of the asset or the portfolio to changes in the markets; risk-free rate is the expected return on risk-free securities over a time horizon consistent with the investment horizon; and ERP is basically the excess return that market provides over risk-free rate. The general formula used for CAPM is:
Capital Asset Pricing Model Formula
CAPM, a theoretical representation of the behavior of financial markets, is quite significant to the operations of financial world as it serves as a model for pricing the risk in all securities, and thus helps investors evaluate and measure portfolio risk and returns anticipated for taking such risks. The theory contends that investors are rewarded only for assuming systematic risk, because investors can mitigate diversifiable risk by building a portfolio of both risky stocks and sound ones.
Applications Of Capital Asset Pricing Model
One of the major advantage of CAPM is its objective nature of estimating cost of equity which has found various applications in real world as it can be utilized for appraising investments because if the expected return does not meet or beat a theoretical required return, the investment should not be undertaken. For example, when a manager is calculating divisional costs of capital or hurdle rates, the cost of equity component should reflect the risk inherent in the division’s operations rather than the parent company’s risk therefore betas of the independent companies operating in similar industry needs to be assessed where un-levering and re-levering of Beta might be needed to adjust for differences in financial leverage.
This concept can also be applied while performing takeover analysis where discounted cash flow evaluations of acquisition is done to assess the value of operations. In this analysis, the appropriate cost of equity should reflect the risks inherent in the cash flows that are discounted which should ideally reflect the risk level of the target company and not the Acquirer. However, if the target and acquirer are in the same industry, facing similar kind of business risks utilizing either WACC would be deemed appropriate.
Another version of the CAPM utilized for valuing private businesses is known as MODIFIED CAPM. As difficulties are encountered while establishing an appropriate beta that expresses the risk profile of closely held companies based on the volatilities of a group of public companies, thereby a modified version was developed which includes two additional premiums that aids in estimating the required rate of return. It is expressed as:-
Re = Rf + β (Rm- Rf) + SSRP + CSRP
Where, Company Specific Risk Premium (CSRP) is a reflection of the factors solely related to the target company risk profile such as management’s ability, competition etc.; and Small Size Risk Premium (SSRP) is the required rate of return which would compensate for the risks associated with smaller size.
Therefore capital asset pricing model has found wider acceptability in the financial world, however, there is no guarantee that their respective estimated return will be realized, hence investors should utilize CAPM cautiously as beta is a “measure of risk” rather than an “indication of high return”.