CAPM typically measures the association between the risk and expected return of a stock portfolio. In this paper, we will discuss how CAPM is used to estimate the cost of equity capital and the expected rate of return. There is a particular type of symmetry when we are looking at the cost of capital to a company compared to the expected return on a stock. Companies may use this measure in determining how much equity they will use to fund a capital budget project. In the calculation assignment, we calculate the expected rate of return through CAPM. The expected rate of return equals the risk-free rate plus the beta times the difference of the expected market rate and the risk-free rate. We can also use the formula to estimate the cost of equity. The cost of equity can then be used to the beta risk of the project and what the discount rate on the cash flow of the project show be.
Weighted Average Capital Cost (WACC)
“The weighted average cost of capital (WACC) is the rate of return that the providers of a company’s capital require, weighted according to the proportion each element bears to the total pool of capital.” (Qatar Financial Center, 2014) It provides a measure similar to the CAPM, which the correct discount rate on cash flow and it also provides the rate of interest of capital. Many financial managers used this measure to make investment decisions while finding the correct capital structure for their company. In the WACC portion of the calculation assignment, we were asked to find the WACC which is the weight of equity within the capital structure multiply by the cost of equity times the inverse of the tax rate plus the weight of debt within the capital structure multiply by the cost of debt. By determining WACC, financial managers can analyze the value the project. The expected rate of return of WACC can be used to determine the risk and the capital structure of the company’s existing assets. This expected rate of return can then be used to calculate NPV to either accept or reject a project.
“Flotation costs are the costs of issuing debt and equity security.” (Tegarden, 2008, p71) Flotation costs can be calculated by reducing the cash flow to discount or including this value when calculating the WACC or discount rate. Often, flotation costs are not accounted for, therefore, affecting the accuracy when calculation for the NPV. Flotation costs are fixed costs usually around 1 to 2 percent of the debt and around 2 to 6 percent of equity, but it can higher, depending on the size and type of industry. In the flotation costs example in calculation assignment, we discussed how flotation cost could play a part in determining the initial cost of building a plant. Ultimately, we need to recognize flotation costs and make an adjustment to the WACC to assist in the decision making of the capital budgeting process.
In conclusion, we have discussed how the concepts of CAPM, WACC and flotation costs influence the financial decision making with the capital budgeting process. A company can determine how the effect of debt and equity has on their capital structure by using WACC and adjusting for flotation costs. These measures will also allow financial managers within an organization to make intelligent investment decisions when it comes to capital budgeting.
Qatar Financial Center (2014). “Weighted average cost of capital,” QFinance: The Ultimate
Resource. Retrieved from: http://search.credoreference.com.contentproxy.phoenix.edu/content/entry/qfinance/weighted_average_cost_of_capital/0?searchId=afd14799-94ad-11e6-9610-0a80f32943a1&result=0
Tegarden, T.K. (2008). “The Appraisal of Public Utilities: Adjustment to the WACC for
Flotation Costs”, Journal of Property Tax Assessment & Administration. Vol. 5, Issue 1,