Cost of Capital: WACC and CAPM
The discount rate must match the cash flow, the currency and the asset's life.
The discount rate turns forecast cash flows into a value today. ICAI Valuation Standard 103 defines it as the return a market participant expects from the investment, reflecting the time value of money, the risk of the asset and the risk of achieving the forecast cash flows.
Two formulas carry most of the work: the capital asset pricing model (CAPM) for the cost of equity, and the weighted average cost of capital (WACC) for the firm as a whole. The SFA syllabus also names modified CAPM, the build-up method, arbitrage pricing theory and the weighted average return on assets (WARA).
You save ₹600
- Full-length mocks
- Case-study practice
- Law module sets
One payment, no subscription · Valid for 2 months
The Formulas
- CAPM
- Cost of equity = risk-free rate + beta × (expected market return − risk-free rate). The bracket is the equity risk premium.
- Modified CAPM
- CAPM plus premiums the market model misses, typically a size premium and a company-specific risk premium for forecast risk or key-person dependence.
- Post-tax cost of debt
- Pre-tax cost of debt × (1 − tax rate), because interest is tax-deductible.
- WACC
- (E ÷ V) × cost of equity + (D ÷ V) × post-tax cost of debt, with E, D and V = E + D at market values or target weights.
- Levered beta
- Unlevered beta × [1 + (1 − tax rate) × D/E]. Unlever peers' betas, average, then relever at the subject's capital structure.
- Build-up method
- Risk-free rate plus stacked premiums, with no beta. VS 103 says it is generally used only in the absence of market inputs.
Worked Example: WACC for an Unlisted Company
Illustrative inputs only: risk-free rate 7%, equity risk premium 7%, peers' unlevered beta 0.9, target D/E 0.5 (so 2/3 equity, 1/3 debt), tax rate 25%, pre-tax cost of debt 10%.
Relevered beta
Working
0.9 × [1 + 0.75 × 0.5]
Result
1.2375
Cost of equity (CAPM)
Working
7% + 1.2375 × 7%
Result
15.66%
Post-tax cost of debt
Working
10% × (1 − 0.25)
Result
7.50%
WACC
Working
(2/3 × 15.66%) + (1/3 × 7.50%)
Result
12.94%
Modified CAPM with 2% company-specific premium
Working
15.66% + 2%
Result
17.66% cost of equity
WACC with the premium
Working
(2/3 × 17.66%) + (1/3 × 7.50%)
Result
14.27%
| Step | Working | Result |
|---|---|---|
| Relevered beta | 0.9 × [1 + 0.75 × 0.5] | 1.2375 |
| Cost of equity (CAPM) | 7% + 1.2375 × 7% | 15.66% |
| Post-tax cost of debt | 10% × (1 − 0.25) | 7.50% |
| WACC | (2/3 × 15.66%) + (1/3 × 7.50%) | 12.94% |
| Modified CAPM with 2% company-specific premium | 15.66% + 2% | 17.66% cost of equity |
| WACC with the premium | (2/3 × 17.66%) + (1/3 × 7.50%) | 14.27% |
Quick practice on loss assessment and valuation basics. No signup.
Consistency Rules From ICAI VS 103
- checkFCFE is discounted at the cost of equity; FCFF at WACC.
- checkPre-tax cash flows take a pre-tax rate; post-tax cash flows take a post-tax rate.
- checkDiscount cash flows in their own currency at a rate for that currency: rupee cash flows, rupee rate.
- checkMatch the risk-free rate to the asset's life: a one-year asset and a perpetual business do not share a risk-free rate.
- checkFor intangible assets, check that the rates used for each asset reconcile to the overall WACC through a weighted average return on assets (VS 302).
How the Valuation Examination Tests This
Expect direct calculations (cost of equity from given inputs, post-tax cost of debt, WACC) and one-mark concept questions on what beta measures or why debt is cheaper than equity. The traps: weighting by book values when market values are given, using the pre-tax cost of debt in WACC, plugging the market return where the formula wants the premium (market return minus risk-free rate), and relevering at the peers' D/E instead of the subject's.
FAQs
What is the difference between WACC and cost of equity?expand_more
Cost of equity is the return shareholders require. WACC blends it with the post-tax cost of debt in proportion to how the business is financed. Use cost of equity for equity cash flows and WACC for firm cash flows.
Why is WACC calculated on market values and not book values?expand_more
Because the weights should reflect what investors' claims are worth today, which is what the discount rate prices. Book values can be far from that for equity. A target capital structure is a common alternative.
What is modified CAPM?expand_more
CAPM with extra premiums, usually for small size or company-specific risk, added to the cost of equity. It is common in valuing unlisted Indian companies whose risks the peer beta does not capture.
Why unlever and relever beta?expand_more
Peers' observed betas include their own debt levels. Unlevering strips that out to get business risk; relevering at the subject's debt-to-equity ratio adds back the subject's financial risk.
Next steps
- DCF valuationarrow_forward
- Intangible assetsarrow_forward
- Syllabusarrow_forward
- SFA mock testarrow_forward
Free study material and a free diagnostic test.