Difference between WACC and Asset Return CAPM
The capital asset pricing model (CAPM) and weighted average cost of capital (WACC) are two fundamental concepts in finance that are often used to evaluate investments and make financial decisions. While both are related to the cost of capital, they serve different purposes and are calculated in distinct ways. This article aims to highlight the key differences between WACC and asset return CAPM.
1. Purpose and Application
The primary purpose of the CAPM is to determine the expected return on an investment based on its risk. It is commonly used by investors to assess the attractiveness of a stock or a portfolio. On the other hand, WACC is a financial metric used to estimate the cost of capital for a company or a project. It represents the weighted average of the cost of equity and the cost of debt, reflecting the overall cost of financing for the entity.
2. Calculation Methodology
The CAPM calculates the expected return on an investment using the following formula:
Expected Return = Risk-Free Rate + Beta (Market Return – Risk-Free Rate)
Here, the risk-free rate is the return on a risk-free investment, beta is a measure of the asset’s volatility compared to the market, and the market return is the expected return of the overall market.
In contrast, WACC is calculated by taking the weighted average of the cost of equity and the cost of debt, as follows:
WACC = (Cost of Equity Weight of Equity) + (Cost of Debt Weight of Debt) (1 – Tax Rate)
The cost of equity is determined using the CAPM, while the cost of debt is the interest rate on the company’s debt.
3. Risk Consideration
The CAPM focuses on the systematic risk of an investment, which is the risk that cannot be diversified away. It measures the asset’s sensitivity to market movements and compares it to the market as a whole. In contrast, WACC considers both systematic and unsystematic risk. The cost of equity component in WACC incorporates the systematic risk, while the cost of debt component reflects the unsystematic risk associated with the company’s specific operations.
4. Time Horizon
The CAPM is typically used to estimate the expected return on an investment over the long term. It assumes that investors are rational and risk-averse, and that they require compensation for bearing risk. WACC, on the other hand, is used to evaluate the cost of capital for a company or a project, which can have a broader time horizon. It is often used in capital budgeting decisions to determine the feasibility of an investment.
In conclusion, the difference between WACC and asset return CAPM lies in their purpose, calculation methodology, risk consideration, and time horizon. While the CAPM is used to estimate the expected return on an investment based on its risk, WACC is a financial metric that represents the cost of capital for a company or a project. Understanding these differences is crucial for investors and financial professionals when making informed decisions.
