WACC and CAPM Flashcards
Using either book/nominal value vs Market value for WACC
Use MV where possible
MV - current
NV/BV - historic cost of finance
if using NV’s, you need to include share premium and retained profit as well as nominal value of share capital
Calculating weights
Equity = MV of each sharenumber of shares in issue
Debt = Total nominal value/100current market value
Limitations of WACC
Assumes:
Historic gearing hasn’t changed
The finance isn’t project specific e.g. from a pool of funds
Operating risk of the firm won’t change
Project is small in relation to the company
Assumes current required return and risk profile won’t change
Total return demanded by investors is dependent upon
The prevailing risk free (Rf) rate of return
The reward for the risk investors take in advancing funds
Therefore:
Required return = risk-free return + risk premium
Risk free rate of return
Minimum rate required by all investors who returns are certain e.g.
Treasury bills/government gilts/debt
Why is CAPM used
CAPM is used to solve the issue that WACC assumes all future investments have the same risk profile and are in the same business area. It quantifies the premium
Shows how the minimum required return is dependent upon risk
Reducing risk through diversification
15-20 diversified will reduce unsystematic risk (company/industry specific factors), but will never solve the issue of systematic risk (market wide factors)
CAPM formula
E(r)i = Rf + Bi*(E(rm)-Rf)
E(r)i = required return on investment
Rf = risk free rate of return
Bi = the beta factor - the systematic risk of the investment compared to the market and therefore the premium required
E(rm) - expected average return on the market (rm)
(E(rm)-Rf) = equity risk premium
Understanding Beta
Beta >1 riskier
Beta <1 less risky than average
Beta =0 risk free
Limitations of CAPM
Assumes
Investors only want return to cover systematic risk as they have a diverse portfolio of 15-20 companies
Perfect capital market:
No tax, transaction costs, perfect information available, all investors risk averse, large number of buyers and sellers
Unrestricted borrowing or lending at a risk free rate of interest
Only focuses on systematic not unsystematic risk
Beta - the measure of systematic risk is purely an estimate
Use of CAPM
Can be rearranged to find return to equity investors:
re = Rf + b*(rm-rf) Basically the same except the Beta is estimated by using a proxy beta of a similar company
Systematic and Unsystematic Risk
Systematic - Market wide risk e.g. Economy
Unsystematic risk = risk that is unique to a company
CAPM Assumptions an
Assumes investors are well diversified and simply seeking a return to at least match systemic risk
